Feedback Between Credit and Liquidity Risk in the US Corporate Bond Market

Abstract

In this paper, we analyze the dynamic interactions between credit and liquidity risk and their impact on bond prices and risk. We propose a novel way of modeling credit-liquidity interactions by using mutually exciting processes and develop a corresponding Bayesian estimation procedure. We show, using US corporate bond transaction data, that there is evidence of feedback between credit and liquidity risk, that this feedback is asymmetric, and stronger for bonds with a low credit rating. Our model allows for a decomposition of bond yield spreads into pure credit, pure liquidity, credit-induced liquidity, and liquidity-induced credit components. We find that, on average, the credit-induced liquidity component accounts for about 8% (AAA/AA) to 17% (B and lower) of total yield spreads, but in the most distressed periods it accounts for over 40%. Our decomposition reveals that the widening of yield spreads during the financial crisis can mainly be attributed to a decrease in market liquidity, which, in turn, is for a substantial part caused by deteriorating credit conditions. Furthermore, we show that credit-liquidity interactions are responsible for a large part of Value-at-Risk bond capital requirements. Ignoring such interactions may result in a severe underestimation of required capital, especially for bonds with lower credit ratings.