Heterogeneous Liquidity Effects in Corporate Bond Spreads

Abstract

Among the many sources of risk explaining corporate bond spreads, the role of liquidity is the least well understood. This paper investigates the impact of liquidity risk of unknown functional form on the yield spread over time. Heterogeneity is introduced via a latent group structure explaining differences in nonlinear liquidity effects across groups. A key feature of the model is that it can be estimated from highly unbalanced longitudinal data, allowing us to work with data at minimum levels of temporal aggregation. In an extensive empirical study we apply the suggested method to a large panel of trade data for US corporate bonds. Our procedure identifies nonlinear liquidity effects for a large fraction of the securities. Nonlinearities become more pronounced as bond-idiosyncratic illiquidity increases. The classification clearly distinguishes groups differing e.g. in bond characteristics such as spread levels and trading activity. While groups share similar dynamics of liquidity effects, their magnitudes as well as the interplay between idiosyncratic and market illiquidity are different across groups.

Flight from Liquidity and Corporate Bond Yields

“…illiquid bonds compensate investors in the form of higher yields. (see for example Longstaff, Mithal, and Neis, 2005;Chen, Lesmond and Wei, 2007;Bao, Pan and Wang, 2011;Dick-Nielsen et al 2012;Friewald, Jankowitsch, and Subrahmanyam, 2012;Helwege et al 2014;Hafner and Walders, 2017). Our second finding, however, is new and arguably driven by the selling pressure on liquid bonds as a result of flight from liquidity.…”

“…2012; Friewald, Jankowitsch, and Subrahmanyam, 2012; Helwege et al. 2014; Hafner and Walders, 2017). Our second finding, however, is new and arguably driven by the selling pressure on liquid bonds as a result of flight from liquidity.…”

“…In the bond market, liquidity has been shown to have a significant impact on bond prices/yields, i.e. more liquid bonds tend to be more expensive and have lower yield (see for example Longstaff, Mithal, and Neis, 2005;Driessen 2005;Chen, Lesmond, and Wei, 2007;Bao, Pan, and Wang, 2011;Dick-Nielsen, Feldhutter, and Lando, 2012;Friewald, Jankowitschn, and Subrahmanyam, 2012;Chen, Huang, Sun, Yao, and Yu, 2020;Helwege, Huang, and Wang, 2014;Han and Zhao, 2016;Hafner and Walders, 2017). Acharya et al (2013) use a regime-switching model and show that the effect of market-wide liquidity shocks on bond prices can vary.…”