Stock Liquidity and Corporate Bond Yield Spreads: Theory and Evidence

Abstract

We examine the impact of individual stock liquidity on corporate bond yield spreads in the U.S. market. By extending the endogenous‐default model to include stock liquidity in the calculation of bond value we show that a drop in stock liquidity will increase the firm's credit risk by increasing the firm's default boundary, leading to an increase of the credit spread. Our model is consistent with the sharp increase in credit risk premiums and the “yield spread spike” phenomenon in corporate bond markets during the financial crisis. We present empirical evidence supportive of our model.

Are Low Equity R2 Firms More or Less Transparent? Evidence from the Corporate Bond Market

“…We employ three measures to control for liquidity risk. Issue Size is associated with secondary market depth where larger issue size reflects less liquidity risk (Lu et al., ; Huang, Huang, and Oxman, ). For the sample of seasoned bonds, we also include logged Bond Age (Lu et al., ; Huang et al., ), logged Bond Trade Volume and the number of transaction days per year ( Bond Trade Days ) as additional liquidity measures.…”

Determinants of Corporate Bond Yield: The Case of Malaysian Bond Market

“…Liquidity risk is another significant determinant of bond yield reported in the literature (e,g, Helwege et al 2014, Huang et al 2015, Rossi 2014. For example, Gajalla 2006suggests liquidity risk is replicated by the trading frequency.…”

Lenders’ Response to Peer and Customer Restatements

“…Prior research presents conflicting arguments as to whether bid-ask spread is positively or negatively related to default risk. Agrawal et al (2015) and Huang et al (2015) find that reduced stock liquidity is a leading indicator of financial distress, suggesting a positive association between bid-ask spread and bank loan spread. On the other hand, Goldstein and Guembel (2008) argue that high liquidity in a stock creates incentives for uninformed investors to manipulate stock price through sell orders, thus driving the price of a firm's stock downward.…”