Liquidity and default risks in corporate bonds

Abstract

This study reveals that both liquidity and default risks are the main factors affecting the yield spreads of corporate bonds in an international market. Using two measures of liquidity (the percentage of zero returns and the limited dependent variable estimate of Lesmond, Ogden, and Trzcinka (1999) or LOT measure) and two measures of default (probability of default and credit scoring) on a dataset of over 8,000 bond-years in five countries consisting of Canada, France, Japan, United Kingdom, and United States, this study finds that both liquidity and default risks are significantly and positively associated with yield spreads. However, when extending the study to change in yield spreads, it is found that only an increase in liquidity risk is significantly and positively associated with an increase in yield spreads, implying that only change in liquidity risk is the main factor that drives corporate bonds yield spread change in an international market. Moreover, this study constructs bond portfolios by using liquidity and default measures criteria. This study finds that the alphas are significantly and positively associated with yield spreads and strongly increase as the portfolios proceed from less to more liquidity risk and less to more default risk. It can be concluded that both liquidity and default risks are consistent with yield spreads in an international market.