Three essays in corporate bond liquidity

Abstract

This dissertation consists of three chapters. In the first chapter, using proxies for conversion cost parameters in conjunction with a special set of default free corporate bonds, I empirically establish that the term structure of liquidity spreads was positively sloped in the financial crisis period of 2008 and negatively sloped in the subsequent post crisis period. Importantly, these results indicate the segment of the term structure that provides the largest liquidity premiums to lenders for alternative economic scenarios. At the same time, for different financial epochs, the liquidity spreads associated with different times to maturity are clear to those who issue debt. In the second chapter, across credit ratings for alternative financial scenarios, I obtain the term structures of corporate bond liquidity premia using an enhanced version of a classic debt valuation equation. For purposes of estimation, unscented transformations (UT) accommodate the nearly two dozen nonlinear appearances of liquidity premiums in the determination of a bond’s yield. A Kalman filter then extracts the otherwise latent liquidity premiums from the observed yield. I find that the term structures of liquidity premiums were upward sloping for all credit ratings and in all three economic epochs considered. In addition, the structures were much steeper during the financial crisis and steeper for lower quality bonds across all three scenarios. I also empirically establish that the magnitude of the liquidity premiums more than doubled during the recent financial crisis relative to the pre-crisis period. Furthermore, the liquidity premiums do not retreat to their pre-crisis level after the financial crisis. Finally, in the third chapter, using a classical model of debt valuation that acknowledges liquidity premiums, I study how corporate bond market illiquidity may result in an elevated likelihood of the issuer’s default. Clearly, these liquidity considerations should be included in the pricing of securities that depend on credit risk, such as credit default swaps (CDS). Empirical analyses suggest that increases in bond illiquidity measures result in a heightened likelihood of the issuer’s default and occasion a greater price of its CDS contracts. I also establish that the impact of illiquidity upon CDS premiums is more severe for less creditworthy issuers and in periods of financial stress.