Abstract
Our main objective in this paper is to determine empirically the extent to which fixed-income investors are concerned about equity volatility and bond liquidity in corporate bond spreads. We extend Campbell and Taksler (2003) by conditioning for underlying bond liquidity, and exploring the relative contribution of idiosyncratic equity volatility and bond liquidity in the cross-sectional pricing of corporate bond spreads. Portfolio analysis and Fama-Macbeth regressions reveal that while both volatility and liquidity effects are significant, volatility (representing ex-ante credit shock) has the first-order impact, and liquidity (represented by bond characteristics and price impact measure) has the secondary impact on bond spreads. Conditional analysis further reveals that distressed bonds and distress regimes are both associated with significantly higher impact of credit and liquidity shocks. However, the relative impact of these shocks varies. Volatility effects are more prominent for distressed bonds and during high-distress regimes; liquidity effects are stronger for less distressed bonds and during low-distress regimes. Our findings also indicate that, unlike equity markets, idiosyncratic risk does not subsume the information in liquidity in explaining corporate bond spreads.
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