Estimating liquidity premium of corporate bonds using the spread information in on- and off-the-run Treasury securities

Haitao Li, Chunchi Wu and Jian Shi

China Finance Review International, 2017, vol. 7, issue 2, 134-162

Abstract: Purpose - The purpose of this paper is to estimate the effects of liquidity on corporate bond spreads. Design/methodology/approach - Using a systematic liquidity factor extracted from the yield spreads between on- and off-the-run Treasury issues as a state variable, the authors jointly estimate the default and liquidity spreads from corporate bond prices. Findings - The authors find that the liquidity factor is strongly related to conventional liquidity measures such as bid-ask spread, volume, order imbalance, and depth. Empirical evidence shows that the liquidity component of corporate bond yield spreads is sizable and increases with maturity and credit risk. On average the liquidity spread accounts for about 25 percent of the spread for investment-grade bonds and one-third of the spread for speculative-grade bonds. Research limitations/implications - The results show that a significant part of corporate bond spreads are due to liquidity, which implies that it is not necessary for credit risk to explain the entire corporate bond spread. Practical implications - The results show that returns from investments in corporate bonds represent compensations for bearing both credit and liquidity risks. Originality/value - It is a novel approach to extract a liquidity factor from on- and off-the-run Treasury issues and use it to disentangle liquidity and credit spreads for corporate bonds.

Keywords: Liquidity premium; Kalman filter; Equivalent martingale measure; On- and off-the-run spreads; Reduced-form model; G01; G1 (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eme:cfripp:cfri-11-2016-0125

DOI: 10.1108/CFRI-11-2016-0125

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