Liquidity and Credit Risk

We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years, we find evidence of a positive correlation between the illiquidity and default components of yield spreads as well as support for downward-sloping term structures of liquidity spreads. CREDIT RISK AND LIQUIDITY RISK HAVE LONG been perceived as two of the main justifications for the existence of yield spreads above benchmark Treasury notes or bonds (see Fisher (1959)). Since Merton (1974), a rapidly growing body of literature has focused on credit risk.1 However, while concern about market liquidity issues has become increasingly marked since the autumn of 1998,2 liquidity remains a relatively unexplored topic, in particular, liquidity for defaultable securities.3 This paper develops a structural bond pricing model with liquidity and credit risk. The purpose is to enhance our understanding of both the interaction between these two sources of risk and their relative contributions to the yield spreads on corporate bonds. Throughout the paper, we define liquidity as the ability to sell a security promptly and at a price close to its value in frictionless markets, that is, we think of an illiquid market as one in which a sizeable discount may have to be incurred to achieve immediacy. We model credit risk in a framework that allows for debt renegotiation as in Fan and Sundaresan (2000). Following François and Morellec (2004), we also introduce uncertainty with respect to the timing and occurrence of liquidation ∗Ericsson is from McGill University and the Swedish Institute for Financial Research; Renault is from the Fixed Income Quantitative Research group of Citigroup Global Markets Ltd. and the Financial Econometrics Research Centre at the University of Warwick. 1 See for example Black and Cox (1976), Kim, Ramaswamy, and Sundaresan (1993), Shimko, Tejima, and van Deventer (1993), Nielsen, Saá-Requejo, and Santa-Clara (1993), Longstaff and Schwartz (1995), Anderson and Sundaresan (1996), Jarrow and Turnbull (1995), Lando (1998), Duffie and Singleton (1999), and Collin-Dufresne and Goldstein (2001). 2 Indeed, the BIS Committee on the Global Financial System underlines the need to understand the sudden deterioration in liquidity during the 1997 to 1998 global market turmoil. See BIS (1999). 3 Some recent empirical work with reduced-form credit risk models allows for liquidity risk. Examples include Duffie, Pedersen and Singleton (2003), Janosi, Jarrow and Yildirim (2002), and Liu, Longstaff and Mandell (2006).