Finance and Economics Discussion Series

Effects of Liquidity on the Nondefault Component of Corporate Yield Spreads: Evidence from Intraday Transactions Data

Song Han and Hao Zhou
2008-40

Abstract: We estimate the nondefault component of corporate bond yield spreads and examine its relationship with bond liquidity. We measure bond liquidity using intraday transactions data and estimate the default component using the term structure of credit default swaps spreads. With swap rate as the risk free rate, the estimated nondefault component is generally moderate but statistically significant for AA-, A-, and BBB-rated bonds and increasing in this order. With Treasury rate as the risk free rate, the estimated nondefault component is the largest in basis points for BBB-rated bonds but, as a fraction of yield spreads, it is the largest for AAA-rated bonds. We find a positive and significant relationship between the nondefault component and illiquidity for investment-grade bonds but no significant relationship for speculative-grade bonds. In addition, the nondefault component comoves with macroeconomic conditions--negatively with the Treasury term structure and positively with the stock market implied volatility.

Keywords: Corporate bond yield spreads, credit default swaps, liquidity