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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

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. Authors have furnished an Internet Appendix, which is available on the Oxford University Press website next to the link to the final published paper online.

DOI

10.1093/rfs/hhx107

Volume

31 (3)

Pages

852-897

Language

en

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