Working Paper: NBER ID: w18408
Authors: Zhiguo He; Konstantin Milbradt
Abstract: This paper studies the interaction between fundamental and liquidity for defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond's endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Earlier endogenous default worsens a bond's secondary market liquidity, which amplifies equity holders' rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoff between liquidity provision and inefficient default.
Keywords: Endogenous liquidity; Defaultable bonds; Corporate finance; Credit spreads
JEL Codes: E44; G01; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| earlier endogenous default (G33) | worsens a bond's secondary market liquidity (G10) |
| worsens a bond's secondary market liquidity (G10) | amplifies equity holders' rollover losses (G32) |
| amplifies equity holders' rollover losses (G32) | leads to earlier default (G33) |
| lower liquidity (G19) | increases default risk (G33) |
| increases default risk (G33) | reduces liquidity further (G33) |
| endogenous bid-ask spread (G19) | negatively correlated with the firm's distance to default (G33) |
| firm's distance to default (G33) | decrease in liquidity (E41) |