NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Endogenous Liquidity and Defaultable Bonds

Zhiguo He, Konstantin Milbradt

NBER Working Paper No. 18408
Issued in September 2012
NBER Program(s):   AP   CF   EFG

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.

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Document Object Identifier (DOI): 10.3386/w18408

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