Insolvency or Liquidity Squeeze? Explaining Very Short-Term Corporate Yield Spreads

by Dan Covitz of the Federal Reserve Board, and
Chris Downing of Rice University

October 2, 2002

Abstract: In the first section of this paper, we document new stylized facts about very short-term (less than one year) and long-term investment-grade corporate yield spreads. We find that short-term yield spreads are sizable, averaging from 10 basis points on overnight commercial paper issued by firms with AAA long-term debt ratings, to 34 basis points on overnight paper issued by firms with BBB ratings. We also show that, at times, the correlations between many firms' short-term and long-term yield spreads are negative, typically during periods characterized by credit market disruptions. We then argue that the structural models of risky debt that have appeared in the literature cannot be reconciled with either of these stylized facts.

In the second section of this paper, we develop a structural model that generates levels and correlations of short-term and long-term risk spreads that are more consistent with what we observe. Our model departs from the literature by allowing for the possibility of payment delays when a firm's liquid asset position deteriorates. In essence, we weaken the assumption of perfect firm liquidity that is standard in insolvency-based models of defaultable debt. Intuitively, liquidity risk can generate sizable short-term debt spreads because the realized returns on short-term investments are relatively more sensitive to small increases in the length of the holding period. The presence of liquidity risk can also explain negative correlations between short-term and long-term spreads because liquidity risk need not be perfectly correlated with insolvency risk.

In the third section of the paper, using firm-level pricing and balance sheet information, we provide empirical evidence that, controlling for insolvency risk, liquid asset positions are important for the pricing of short-term debt, particularly during periods of credit market disruptions, but almost never matter for the pricing of long-term debt. The results are robust to different insolvency risk and liquidity risk measures. These results have implications for the pricing and hedging of short-term debt.

JEL Classification: E4, G1, G3.

Keywords: Yields, spreads, default, insolvency, liquidity.

Published in: Journal of Finance, Vol. 62, No. 5, (October 2007), pp. 2303-2328.

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