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.     

A Multifactor Model of Credit Spreads

We represent credit spreads across ratings as a function of common unobservable factors of the Vasicek form. Using a state-space approach we estimate the factors, their process parameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of structural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also contribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a systematic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to macroeconomic variables. This suggests that if credit spread levels do contain a large liquidity premium, the time variation of this premium is likely driven by the same factors as default risk.     

A time-varying common risk factor affecting corporate yield spreads

A time-varying common risk factor affecting corporate yield spreads is modelled by extending a panel data model. The panel data model accommodates a common factor, which is associated with time-varying individual effects. The factor multiplied by a bond-specific unobservable is identified as a systematic risk premium. In disentangling the systematic risk premium, both credit and liquidity risks are evaluated; the credit risk is assessed by bond rating, and the liquidity risk is indirectly measured by discrepancy in quoted yields by brokerage firms. Parameters are estimated by the generalized method of moments procedure. The model is tested on the corporate bond market in Japan. Empirical results show that the time-varying common risk factor is successfully estimated together with credit and liquidity risks.     

Credit lines as monitored liquidity insurance: Theory and evidence

We propose a theory of credit lines provided by banks to firms as a form of monitored liquidity insurance. Bank monitoring and resulting revocations help control illiquidity-seeking behavior of firms insured by credit lines. The cost of credit lines is thus greater for firms with high liquidity risk, which in turn are likely to use cash instead of credit lines. We test this implication for corporate liquidity management by identifying exogenous shocks to liquidity risk of firms in corporate bond and equity markets. Firms experiencing increases in liquidity risk move out of credit lines and into cash holdings.     

Labor Unions and Forms of Corporate Liquidity

We examine how the presence of labor unions affects a firm's choice of corporate liquidity between bank lines of credit and corporate cash holdings. We find that firms in industries with higher unionization rates hold a higher fraction of corporate liquidity in the form of bank lines of credit. We divide the firms into sub‐groups and find that this positive relationship holds for firms that are not in a state with right‐to‐work legislation and for firms that are financially constrained. Our findings are consistent with the hypothesis that a firm chooses the forms of corporate liquidity to take advantage of the bargaining benefits associated with bank lines of credit.     

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.     

Liquidity risk and expected corporate bond returns

This paper studies the pricing of liquidity risk in the cross section of corporate bonds for the period from January 1994 to March 2009. The average return on bonds with high sensitivities to aggregate liquidity exceeds that for bonds with low sensitivities by about 4% annually. The positive relation between expected corporate bond returns and liquidity beta is robust to the effects of default and term betas, liquidity level, and other bond characteristics, as well as to different model specifications, test methodologies, and a variety of liquidity measures. The results suggest that liquidity risk is an important determinant of expected corporate bond returns.     

On the Term Structure of Default Premia in the Swap and LIBOR Markets

Existing theories of the term structure of swap rates provide an analysis of the Treasury–swap spread based on either a liquidity convenience yield in the Treasury market, or default risk in the swap market. Although these models do not focus on the relation between corporate yields and swap rates (the LIBOR–swap spread), they imply that the term structure of corporate yields and swap rates should be identical. As documented previously (e.g., in Sun, Sundaresan, and Wang (1993)) this is counterfactual. Here, we propose a model of the default risk imbedded in the swap term structure that is able to explain the LIBOR–swap spread. Whereas corporate bonds carry default risk, we argue that swap contracts are free of default risk. Because swaps are indexed on "refreshed"-credit-quality LIBOR rates, the spread between corporate yields and swap rates should capture the market's expectations of the probability of deterioration in credit quality of a corporate bond issuer. We model this feature and use our model to estimate the likelihood of future deterioration in credit quality from the LIBOR–swap spread. The analysis is important because it shows that the term structure of swap rates does not reflect the borrowing cost of a standard LIBOR credit quality issuer. It also has implications for modeling the dynamics of the swap term structure.     

The use of bank lines of credit in corporate liquidity management: A review of empirical evidence

This paper reviews empirical evidence on the use of bank lines of credit as a source of corporate liquidity. Traditional explanation for lines of credit is that they provide insurance against liquidity shocks, in much the same as way hoarding cash does. However, recent empirical research suggests that access to lines of credit is contingent on the credit quality of the borrower as well as the financial condition of the lender. These findings suggest that lines of credit are an imperfect substitute for cash as a source of corporate liquidity.     

A jump-diffusion model for pricing corporate debt securities in a complex capital structure

This paper proposes a jump-diffusion model, in closed form, to price corporate debt securities, senior and junior, with the same maturity and violation of the absolute priority rule. We take the structural approach that the firm's asset value follows a jump-diffusion process in a stochastic interest rate economy. Default occurs only if the firm value at the maturity of the corporate debts is less than the sum of the prespecified face values. Unlike previous models in the structural approach, our model is consistent with the current term structures of credit spreads for both senior and junior debts. In particular, it captures realistic short maturity credit spreads observed in the market. The key idea is to allow the jump intensity to be a time-dependent function. As an application, valuation of credit spread options is presented.     

A theory of corporate financial decisions with liquidity and solvency concerns

This paper studies the impact of both liquidity and solvency concerns on corporate finance. I present a tractable model of a firm that optimally chooses capital structure, cash holdings, dividends, and default while facing cash flows with long-term uncertainty and short-term liquidity shocks. The model explains how changes in solvency affect liquidity and also how liquidity concerns affect solvency via capital structure choice. These interactions result in a dynamic cash policy in which cash reserves increase in profitability and are positively correlated with cash flows. The optimal dividend distributions implied by the model are smoothed relative to cash flows. I also find that liquidity concerns lead to a decrease of dispersion of credit spreads.     

Rollover Risk and Credit Risk

Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms' debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debt holders are paid in full. This conflict leads the firm to default at a higher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short‐term debt in exacerbating rollover risk.     

Optimal capital structure: A multi-period programming model for use in financial planning

This paper describes a multi-period, chance constrained mathematical programming model to compute for each period, the firm's optimal debt to equity ratio and the optimal maturity distribution of its debt. The model assumes that the firm's objective is to maximize total value of the firm, and that the firm operates in a world of uncertainty, with corporate income taxes and bankruptcy costs. Finally, the actual coupon rate paid by the firm which is commensurate to the risk of default is endogenously determined by the model.     

What determines the composition of a firm's cash reserves?

We investigate what determines variation in the composition of the financial assets that constitute corporate cash reserves and how this variation relates to other key liquidity management practices. The degree to which a firm invests its cash reserves in less liquid, longer-maturity financial assets that earn a higher yield is explained by financial constraints, the ability to accurately forecast short-term liquidity needs, and the firm's likelihood of defaulting on its debt. During years when a firm's cash reserves are required to fund increases in investment or operating expenses the firm transfers funds from less liquid to more liquid financial assets. A firm's decisions relating to the composition of its cash reserves interacts with other key liquidity management practices, such as relying on credit lines for liquidity, extending trade credit or using it as a source of financing, and holding large amounts of inventories. Our findings provide insights on an important component of corporate liquidity management decisions.     

Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds

Structural models of credit risk provide poor predictions of bond prices. We show that, despite this, they provide quite accurate predictions of the sensitivity of corporate bond returns to changes in the value of equity (hedge ratios). This is important since it suggests that the poor performance of structural models may have more to do with the influence of non-credit factors rather than their failure to capture the credit exposure of corporate debt. The main result of this paper is that even the simplest of the structural models [Merton, R., 1974. On the pricing of corporate debt: the risk structure of interest rates. Journal of Finance 29, 449–470] produces hedge ratios that are not rejected in time-series tests. However, we find that the Merton model (with or without stochastic interest rates) does not capture the interest rate sensitivity of corporate debt, which is substantially lower than would be expected from conventional duration measures. The paper also shows that corporate bond prices are related to a number of market-wide factors such as the Fama-French SMB (small minus big) factor in a way that is not predicted by structural models.     

A Crisis of Banks as Liquidity Providers

Can banks maintain their advantage as liquidity providers when exposed to a financial crisis? While banks honored credit lines drawn by firms during the 2007 to 2009 crisis, this liquidity provision was only possible because of explicit, large support from the government and government‐sponsored agencies. At the onset of the crisis, aggregate deposit inflows into banks weakened and their loan‐to‐deposit shortfalls widened. These patterns were pronounced at banks with greater undrawn commitments. Such banks sought to attract deposits by offering higher rates, but the resulting private funding was insufficient to cover shortfalls and they reduced new credit.     

Measuring Corpotate Liquidity Risk

This article presents the outline of a framework for evaluating liquidity risk (at the corporate level) with risk measures that are intuitive and economically relevant. In particular, the risk measures are designed explicitly to show the effectiveness of a company's risk management program in helping the firm to (1) avoid financial distress or default and (2) ensure its ability to undertake all strategic investments. For managers attempting to quantify liquidity risks, this paper proposes that the risk measures have two important features: One is to make the liquidity risk estimate depend on some measure of the firm's balance sheet strength, one that reflects the role of the balance sheet as a risk buffer. The second is to provide a useful estimate of the opportunity costs associated with a given liquidity shortage—one that reflects the value of the investment opportunities that liquidity problems could jeopardize. The author illustrates the application of the proposed risk measures with an example of a company evaluating a hedging strategy designed to accompany a substantial increase in its investment budget. Using the risk measures discussed in this paper, the author shows how to assess the effectiveness of a proposed hedge in terms of its expected ability to reduce costly cash shortfalls in scenarios in which the firm's debt capacity is also expected to be depleted.     

Comparing possible proxies of corporate bond liquidity

We consider nine different proxies (issued amount, listed, euro, on-the-run, age, missing prices, yield volatility, number of contributors and yield dispersion) to measure corporate bond liquidity and use a four-variable model to control for interest rate risk, credit risk, maturity and rating differences between bonds. The null hypothesis that liquidity risk is not priced in our data set of euro corporate bonds is rejected for eight out of nine liquidity proxies. We find significant liquidity premia, ranging from 13 to 23 basis points. A comparison test between liquidity proxies shows limited differences between the proxies.     

Liquidity risk in securities settlement

This paper studies the potential impact on securities settlement systems (SSSs) of a major market disruption, caused by the default of the largest player. A multi-period, multi-security model with intraday credit is used to simulate direct and second-round settlement failures triggered by the default, as well as the dynamics of settlement failures, arising from a lag in settlement relative to the date of trades. The effects of the defaulter’s net trade position, the numbers of securities and participants in the market, and participants’ trading behavior are also analyzed.We show that in SSSs – contrary to payment systems – large and persistent settlement failures are possible even when ample liquidity is provided. Central bank liquidity support to SSSs thus cannot eliminate settlement failures due to major market disruptions. This is due to the fact that securities transactions involve a cash leg and a securities leg, and liquidity can affect only the cash side of a transaction. Whereas a broad program of securities borrowing and lending might help, it is precisely during periods of market disruption that participants will be least willing to lend securities.Settlement failures can continue to occur beyond the period corresponding to the lag in settlement. This is due to the fact that, upon observation of a default, market participants must form expectations about the impact of the default, and these expectations affect current trading behavior. If, ex post, fewer of the previous trades settle than expected, new settlement failures will occur. This result has interesting implications for financial stability. On the one hand, conservative reactions by market participants to a default – for example by limiting the volume of trades – can result in a more rapid return of the settlement system to a normal level of efficiency. On the other hand, limitation of trading by market participants can reduce market liquidity, which may have a negative impact on financial stability.     

债券信用溢价的共同因子与结构变化:基于机器学习方法

共同因子是刻画风险溢价的重要基础,将共同因子模型应用于公司债券市场有助于合理估计信用风险溢价.本文利用机器学习算法探究债券信用溢价因子的存在性以及结构变化后发现:规模、下行风险、价值、波动率以及流动性等五个公司债券共同因子对单个债券信用溢价有较好的解释能力,动量因子对信用溢价的解释能力较差,流动性因子具有较强的逆周期防...