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We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.A NUMBER OF RECENT STUDIES (Collin-Dufresne, Goldstein, and Martin (2001) and Huang and Huang (2003)) indicate that neither levels nor changes in the yield spread of corporate bonds over Treasury bonds can be fully explained by credit risk determinants proposed by structural form models. Longstaff, Mithal, and Neis (2005) suggest that illiquidity may be a possible explanation for the failure of these models to more properly capture the yield spread variation. Yet much of the current literature abstracts from liquidity's inf luence (Elton et al. (2001), focuses on aggregate liquidity proxies (Grinblatt (1995), Duffie and Singleton (1997), Collin-Dufresne et al. (2001), andTaksler (2003) or assumes that simply the unexplained portion of the yield spread is liquidity based (Duffee (1999)). This paper comprehensively assesses bond-specific liquidity for a broad spectrum of corporate investment grade and speculative grade bonds and examines the association between bond-specific liquidity estimates and corporate bond yield spreads.

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