Corporate Yield Spreads and Bond Liquidity
by Long Chen of Michigan State University,
Abstract: We examine the importance of liquidity in corporate yield spreads. We propose a model to estimate liquidity costs for corporate bonds using only daily bond prices. Extensive robustness checks indicate that zero returns, and the estimates predicated on this liquidity influence, are highly associated with the bid-ask spread even after controlling for the commonly used liquidity determinants of maturity, bond age, the amount outstanding, and bond rating. Assessing the economic significance of our liquidity estimate in relation to the yield spread, we find that our estimate of liquidity is positively associated with both yield spread levels and yield spread changes. This relation holds regardless of controlling for the yield spread level determinants of Campbell and Taksler (2003) or yield spread change determinants of Collin-Dufresne, Goldstein, and Martin (2001). These results have important implications for bond investment and yield spread studies given the demonstrable influence of liquidity on bond returns and the sizeable portion of the yield spread explained by liquidity.
Published in: Journal of Finance, Vol. 62, No. 1, (February 2007), pp. 119-149.
Previously titled: An Indirect Estimate of Transaction Costs for Corporate Bonds