NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle

Hui Chen, Rui Cui, Zhiguo He, Konstantin Milbradt

NBER Working Paper No. 20638
Issued in October 2014
NBER Program(s):   AP   CF

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.

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Document Object Identifier (DOI): 10.3386/w20638

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