Latent Liquidity and Corporate Bond Yield Spreads.pdf

Latent Liquidity and Corporate Bond Yield Spreads Amrut Nashikkar? Marti Subrahmanyam? Sriketan Mahanti? November 16, 2007 Abstract Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their risk-less benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds, as measured by their ease of market access, to the basis between the credit default swap (CDS) price of the issuer and the par-equivalent corporate bond yield spread. The ease of access of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk negatively affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond. Furthermore, we find that when default risk of a firm is high, its illiquid bonds are more expensive. We also document that bond-level variables related to features of the contract that may be related to credit risk, such as the presence of covenants, have a negative impact on the CDS-bond basis. These findings are consistent with limits to arbitrage between the CDS and bond markets, due to the costs of “shorting” bonds. JEL Classification: G100 (General Financial Markets) Keywords: Corporate Bonds, Credit Risk, Credit Default Swaps, Basis, Liquidity, Latent Liquidity We acknowledge the generous support of State Street Corporation in providing the resources for conducting the research repo