Working Paper: NBER ID: w20638
Authors: Hui Chen; Rui Cui; Zhiguo He; Konstantin Milbradt
Abstract: We develop a structural credit risk model to examine how the interactions of liquidity and default risk affect corporate bond pricing. By explicitly modeling debt rollover and by endogenizing the holding costs via collateralized financing, our model generates rich links between liquidity risk and default risk. The introduction of macroeconomic risks helps the model capture realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, our calibrated model can simultaneously match the average default probabilities, credit spreads, and bond liquidity measures including Bond-CDS spreads and bid-ask spreads in the data. Through a structural decomposition, we show that the interactions between liquidity and default risk account for 25∼40% of the observed credit spreads and up to 55% of the credit spread changes over the business cycle. As an application, we use this framework to quantitatively evaluate the effects of liquidity-provision policies for the corporate bond market.
Keywords: Corporate Bonds; Liquidity Risk; Default Risk; Credit Spreads
JEL Codes: G00; G1; G12; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity shocks (E44) | increased holding costs (R21) |
| increased holding costs (R21) | raise the probability of default (G33) |
| liquidity and default risk interactions (G33) | observed credit spreads (G19) |
| liquidity and default risk interactions (G33) | credit spread changes over the business cycle (E32) |
| government liquidity provision policies (E52) | reduce credit spreads during recessions (E44) |
| liquidity-driven default component (G33) | reduction in credit spreads (G19) |
| higher credit ratings (G21) | more liquid bonds (G12) |
| liquidity deteriorates during economic downturns (E44) | riskier bonds (G12) |