Abstract
This paper investigates whether marketwide liquidity is an important state variable for corporate bond pricing. We focus on the systematic risk of corporate bond returns, as opposed to the traditional microstructure-based measures of liquidity. We find that expected corporate bond returns are significantly related cross-sectionally to systematic liquidity risk. The premium of liquidity risk is positive in that bonds with higher sensitivity to aggregate liquidity have higher expected returns. The size of the liquidity risk premium is of economic significance. The effect of liquidity risk remains quite significant even after controlling for the effects of other risk factors and bond characteristics. Results suggest that liquidity risk is a key determinant of required corporate bond returns.
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