Downside risk and the size of credit spreads

We investigate why spreads on corporate bonds are so much larger than expected losses from default. Systematic factors make very little contribution to spreads, even if higher moments or downside effects are taken into account. Instead we find that sizes of spreads are strongly related to idiosyncratic-risk factors: not only to idiosyncratic equity volatility, but even more to idiosyncratic bond volatility and idiosyncratic bond value-at-risk. Idiosyncratic bond volatility helps to explain spreads because it reflects not just the distribution of firm value but is also a proxy for liquidity risk. Idiosyncratic bond value-at-risk adds to this by capturing the left-skewness of the firm-value distribution. We confirm our results both for the initial 1997-2004 sample period and also out of sample for 2005-2009, which includes the sub-prime crisis. Overall, credit spreads are large because they incorporate a large risk premium related to investors’ fears of extreme losses.     

Idiosyncratic volatility vs. liquidity? Evidence from the US corporate bond market

Our objective in this paper is to determine empirically the extent to which fixed-income investors are concerned about the relative effects of equity volatility and bond liquidity in the cross-section of corporate bond spreads. Our tests 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 volatility and liquidity shocks. However, the relative impact of these effects varies conditional on the underlying bond attributes and overall market conditions.     

Liquidity risk of corporate bond returns: conditional approach

We study the exposure of the US corporate bond returns to liquidity shocks of stocks and Treasury bonds over the period 1973–2007 in a regime-switching model. In one regime, liquidity shocks have mostly insignificant effects on bond prices, whereas in another regime, a rise in illiquidity produces significant but conflicting effects: Prices of investment-grade bonds rise while prices of speculative-grade (junk) bonds fall substantially (relative to the market). Relating the probability of these regimes to macroeconomic conditions we find that the second regime can be predicted by economic conditions that are characterized as “stress.” These effects, which are robust to controlling for other systematic risks (term and default), suggest the existence of time-varying liquidity risk of corporate bond returns conditional on episodes of flight to liquidity. Our model can predict the out-of-sample bond returns for the stress years 2008–2009. We find a similar pattern for stocks classified by high or low book-to-market ratio, where again, liquidity shocks play a special role in periods characterized by adverse economic conditions.     

Internal liquidity risk in corporate bond yield spreads

The recent global financial crisis reveals the important role of internal liquidity risk in corporate credit risk. However, few existing studies investigate its effects on bond yield spreads. Panel data for the period from year 1993 through 2008 show that corporate internal liquidity risk significantly impacts bond yield spreads (and changes) when controlling for well-known bond yield determinant variables, traditional accounting measures of corporate debt servicing ability, cash flow volatility, credit ratings, and state variables. This finding indicates that internal liquidity risk should therefore be incorporated into bond yield spread modeling.     

The role of institutional investors in propagating the crisis of 2007–2008

Using novel data on investors' bond portfolios, we study the contagion of the crisis from securitized bonds to corporate bonds. When securitized bonds became “toxic” in August 2007, mutual funds retained the now illiquid securitized bonds and sold corporate bonds. Funds with negative flows or high liquidity needs liquidated more than others. Yield spreads increased more for corporate bonds whose pre-crisis bondholders were more heavily exposed to securitized bonds, compared to same-issuer bonds held by unexposed investors. The findings suggest that liquidity-constrained investors with exposure to securitized bonds played a role in propagating the crisis from securitized to corporate bonds.     

Liquidity shocks and intraday price reaction

Using a global sample of high-frequency data, I investigate how liquidity shocks affect intraday price movements. I find a negative association between liquidity shocks and price impact. This finding remains robust after considering the exogeneity of liquidity shocks, using alternative windows to measure liquidity shocks, and controlling for volume shocks and volatility shocks. Additional tests show that the documented relation stems from idiosyncratic shocks and sell-order shocks. Moreover, I find that liquidity shocks are likely driven by uninformed traders. My evidence suggests that the market requires 30 min to accomplish price adjustments when meeting liquidity shocks.     

The Risk Microstructure of Corporate Bonds: A Case Study from the German Corporate Bond Market

This article presents joint econometric analysis of interest rate risk, issuer‐specific risk (credit risk) and bond‐specific risk (liquidity risk) in a reduced‐form framework. We estimate issuer‐specific and bond‐specific risk from corporate bond data in the German market. We find that bond‐specific risk plays a crucial role in the pricing of corporate bonds. We observe substantial differences between different bonds with respect to the relative influence of issuer‐specific vs. bond‐specific spread on the level and the volatility of the total spread. Issuer‐specific risk exhibits strong autocorrelation and a strong impact of weekday effects, the level of the risk‐free term structure and the debt to value ratio. Moreover, we can observe some impact of the stock market volatility, the respective stock's return and the distance to default. For the bond‐specific risk we find strong autocorrelation, some impact of the stock market index, the stock market volatility, weekday effects and monthly effects as well as a very weak impact of the risk‐free term structure and the specific stock's return. Altogether, the determinants of the spread components vary strongly between different bonds/issuers.     

市场摩擦对特质风险溢价的影响效应——基于A股主板市场的实证分析

与国外发达市场相比,我国A股主板市场的市场摩擦因素对市场微观结构和资产定价的影响更大。在防范和化解系统性风险的过程中,进一步分析市场摩擦如何作用于特质风险定价效应的问题具有重要的理论和现实意义。本文通过采用多维市场摩擦指标来代理信息不对称、交易成本、买卖限制、卖空限制、风险对冲和外部冲击,检验中国股市特质风险和预期收益率的关系,并判断出市场摩擦因素间的差异性影响机制。回归发现,市场摩擦和特质风险因子(特质波动率和特质偏度)都具有定价效应。各维度市场摩擦因素降低了股票流动性,进而增强了特质波动率的负向定价效应,部分解释了“特质波动率之谜”,但市场摩擦对特质偏度因子溢价的影响较为微弱。同时,基于特质波动率和特质偏度因子的投资策略能够产生超越CAPM、三因子和五因子模型的绝对收益,并印证了市场摩擦对特质风险因子绝对收益的影响作用。     

Credit Spread Changes and Equity Volatility: Evidence from Daily Data

We investigate the determinants of daily changes in credit spreads in the U.S. corporate bond market. Using a sample of liquid investment grade and high‐yield bonds, we show that both systematic bond and stock market factors as well as idiosyncratic equity market factors affect changes in the yield spread at the daily frequency. In particular, we find that increase in stock market volatility has a positive effect on changes in the spread of corporate bonds over the corresponding Treasuries beyond that captured by standard term structure variables. Our results show that there is an almost contemporaneous inverse relationship between changes in the bond yield spread and the stock return of the issuing firm.     

Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.     

Bank-specific shocks and the real economy

Governments often justify interventions into the financial system in the form of bail outs or liquidity assistance with the systemic importance of large banks for the real economy. In this paper, we analyze whether idiosyncratic shocks to loan growth at large banks have effects on real GDP growth. We employ a measure of idiosyncratic shocks which follows Gabaix (forthcoming). He shows that idiosyncratic shocks to large firms have an impact on US GDP growth. In an application to the banking sector, we find evidence that changes in lending by large banks have a significant short-run impact on GDP growth. Episodes of negative loan growth rates and the Eastern European countries in our sample drive these results.     

Liquidity shocks,size and the relative performance of hedge fund strategies

We examine whether the increase in the flow of capital to hedge funds over the period 1994–2005 had a negative impact on performance. More specifically, we study the relative performance of small versus large funds for each of the hedge fund strategies. Our results indicate that on an absolute return basis, small funds outperform large funds. On a risk-adjusted return basis, however, we find that large funds outperform small funds, and that large funds are also shown to hold less liquid assets and take on less systematic and idiosyncratic risk than small funds. Further, funds that experience positive liquidity shocks generally outperform those that experience negative liquidity shocks. We also find evidence that hedge fund managers that are aggressive in dealing with liquidity shocks perform better than hedge fund managers that are conservative in dealing with liquidity shocks.     

Price Dynamics and Information Flows in Strategically-Linked Debt Instruments: The NOB and MOB Constituents

We examine information flows between the constituents of the NOB (notes-over-bonds) and MOB (municipals-over-bonds) futures spreads. The results suggest a bicausal relationship between notes and bonds and a unicausal relationship from bonds to municipals. Shocks in the bond market have a large impact on the municipal and note markets, whereas shocks in the municipal or note markets have a smaller impact on the bond market. Volatility spillover from bonds to notes and municipals is detected. We also find significant volatility persistence in all three markets. Spread trades are found to have an asymmetric influence on notes and municipal futures variance.     

Macroeconomic news, announcements, and stock market jump intensity dynamics

This paper examines the effect of macroeconomic releases on stock market volatility through a Poisson-Gaussian-GARCH process with time-varying jump intensity, which is allowed to respond to such information. The day of the announcement, per se, is found to have little impact on jump intensities. Employment releases are an exception. However, when macroeconomic surprises are considered, inflation shocks show persistent effects while monetary policy and employment shocks reveal only short-lived effects. Also, the jump intensity responds asymmetrically to macroeconomic shocks. Evidence on macroeconomic variables relevance in explaining jump dynamics and improving volatility forecasts on event days is provided.     

Liquidity,default, taxes,and yields on municipal bonds

We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model includes liquidity as a state factor. Using a unique transaction dataset, we estimate the liquidity risk of municipals and its effect on bond yields. Empirical evidence shows that municipal bond yields are strongly affected by all three factors. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium accounts for about 9–13% of municipal yields for AAA bonds, 9–15% for AA/A bonds and 8–19% for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in a severe underestimation of municipal bond yields. Conditional on the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and institutional investors. Furthermore, these implicit income tax rates are quite stable across bonds of different maturities. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle.     

The delivery option in credit default swaps

Under standard assumptions the reduced-form credit risk model is not capable of accurately pricing the two fundamental credit risk instruments – bonds and credit default swaps (CDS) – simultaneously. Using a data set of euro-denominated corporate bonds and CDS our paper quantifies this mispricing by calibrating such a model to bond data, and subsequently using it to price CDS, resulting in model CDS spreads up to 50% lower on average than observed in the market. An extended model is presented which includes the delivery option implicit in CDS contracts emerging since a basket of bonds is deliverable in default. By using a constant recovery rate standard models assume equal recoveries for all bonds and hence zero value for the delivery option. Contradicting this common assumption, case studies of Chapter 11 filings presented in the paper show that corporate bonds do not necessarily trade at equal levels following default. Our extension models the implied expected recovery rate of the cheapest-to-deliver bond and, applied to data, largely eliminates the mispricing. Calibrated recovery values lie between 8% and 47% for different obligors, exhibiting strong variation among rating classes and industries. A cross-sectional analysis reveals that the implied recovery parameter depends on proxies for the delivery option, primarily the number of available bonds and bond pricing errors. No evidence is found for a direct influence of the bid-ask spread, notional amount, coupon, or rating used as proxies for bond market liquidity.     

Determinants of yield spread dynamics: Euro versus US dollar corporate bonds

This paper presents a systematic comparison between the determinants of euro and US dollar yield spread dynamics. The results show that US dollar yield spreads are significantly more affected by changes in the level and the slope of the default-free term structure and the stock market return and volatility. Surprisingly, euro yield spreads are strongly affected by the US (and not the euro) level and slope. This confirms the dominance of US interest rates in the corporate bond markets. Interestingly, I find that liquidity risk is higher for US dollar corporate bonds than euro corporate bonds. For both regions, the effect of changes in the bid-ask spread is mainly significant during periods of high liquidity risk. Finally, the results indicate that the credit cycle as measured by the region-specific default probability significantly increases US yield spreads. This is not the case for euro yield spreads.     

Have European Stocks become More Volatile? An Empirical Investigation of Idiosyncratic and Market Risk in the Euro Area

We examine the dynamics of idiosyncratic risk, market risk and return correlations in European equity markets using weekly observations from 3515 stocks listed in the 12 euro area stock markets over the period 1974–2004. Similarly to Campbell et al. (2001) , we find a rise in idiosyncratic volatility, implying that it now takes more stocks to diversify away idiosyncratic risk. Contrary to the US, however, market risk is trended upwards in Europe and correlations are not trended downwards. Both the volatility and correlation measures are pro‐cyclical, and they rise during times of low market returns. Market and average idiosyncratic volatility jointly predict market wide returns, and the latter impact upon both market and idiosyncratic volatility. This has asset pricing and risk management implications.     

The on-the-run liquidity phenomenon

We test the implications of a model of multi-asset speculative trading in which liquidity differentials between on-the-run and off-the-run U.S. Treasury bonds ensue from endowment shocks in the presence of two realistic market frictions—information heterogeneity and imperfect competition among informed traders—and a public signal. Our evidence suggests that (i) off/on-the-run liquidity differentials are economically and statistically significant, even after controlling for several of the bonds’ intrinsic characteristics (such as duration, convexity, repo rates, or term premiums), and (ii) off/on-the-run liquidity differentials are smaller immediately following bond auction dates, and larger when the uncertainty surrounding the ensuing auction allocations is high, when the dispersion of beliefs across informed traders is high, and when macroeconomic announcements are noisy, consistent with our model.     

The effect of interest rate volatility and equity volatility on corporate bond yield spreads: A comparison of noncallables and callables

This research investigates the impact of interest rate volatility upon corporate bond yield spreads. We first consider the impact of interest rate volatility upon noncallable bond spreads. Because greater interest rate volatility likely increases the volatility of the firm's debt, we hypothesize that the relation will be positive. Given that we do find a positive relation, we thus investigate whether the positive effect of interest rate volatility on yield spreads is stronger or weaker for callable bonds. We find that the effect is weaker for callable bonds. This result indicates that there is a negative relation between default spreads and call spreads, which is consistent with the theory of Acharya and Carpenter (2002), but in contrast to the theory of King (2002). Furthermore, our results for the relationship between equity volatility and yield spread tend to support Acharya and Carpenter (2002) more than King (2002).