Review of Financial Studies Vol. 31 No. 3 2018

Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle

Hui Chen¹; Rui Cui²; Zhiguo He³; Konstantin Milbradt⁴

¹ Sloan School of Management, MIT and NBER · ² Booth School of Business, University of Chicago · ³ Booth School of Business, University of Chicago and NBER · ⁴ Kellogg School of Management, Northwestern University, and NBER

Abstract

We develop a structural credit model to examine how interactions between default and liquidity affect corporate bond pricing. The model features debt rollover and bond-price-dependent holding costs. Over the business cycle and in the cross-section, the model matches average default rates and credit spreads in the data, and captures variations in bid-ask and bond-CDS spreads. A structural decomposition reveals that default-liquidity interactions can account for 10%–24% of the level of credit spreads and 16%–46% of the changes in spreads over the business cycle. Further, liquidity-related corporate bond financing costs amount to 6% of the total issuance amount from 1996 to 2015. Received July 12, 2015; editorial decision April 15, 2017 by Editor Andrew Karolyi.

DOI

10.1093/rfs/hhx107

Volume

31

Issue

3

Pages

852-897

Language

en

Sources

crossref openalex

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