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

Abstract

We develop a structural credit risk model to examine how the interactions of liquidity and default risk aect corporate bond pricing. By explicitly modeling debt rollover and by endogenizing the holding costs via collateralized nancing, 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 dierent 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 eects of liquidity-provision policies for