Hostname: page-component-78c5997874-v9fdk Total loading time: 0 Render date: 2024-11-10T20:49:30.557Z Has data issue: false hasContentIssue false
  • English
  • Français

Modelling the liquidity premium on corporate bonds

Published online by Cambridge University Press:  16 February 2015

Paul R.F. van Loon ,
Andrew J.G. Cairns ,
Alexander J. McNeil  and
Alex Veys
Paul R.F. van Loon*
Affiliation:
Actuarial Research Centre and Department of Actuarial Mathematics and Statistics, Heriot-Watt University, EH14 4AS Edinburgh, UK
Andrew J.G. Cairns
Affiliation:
Maxwell Institute for Mathematical Sciences and Department of Actuarial Mathematics and Statistics, Heriot-Watt University, EH14 4AS Edinburgh, UK
Alexander J. McNeil
Affiliation:
Maxwell Institute for Mathematical Sciences and Department of Actuarial Mathematics and Statistics, Heriot-Watt University, EH14 4AS Edinburgh, UK
Alex Veys
Affiliation:
Partnership Assurance, 5th Floor, 110 Bishopsgate, EC2N 4AY London, UK
*
*Correspondence to: Paul R.F. van Loon, Department of Actuarial Mathematics and Statistics, Colin Maclaurin Building, Heriot-Watt University, Riccarton, Edinburgh EH14 4AS, UK; Department of Actuarial Mathematics and Statistics, Heriot-Watt University, Edinburgh, EH14 4AS, UK. E-mail: pv57@hw.ac.uk
Get access Rights & Permissions [Opens in a new window]

Abstract

The liquidity premium on corporate bonds has been high on the agenda of Solvency regulators owing to its potential relationship to an additional discount factor on long-dated insurance liabilities. We analyse components of the credit spread as a function of standard bond characteristics during 2003–2014 on a daily basis by regression analyses, after introducing a new liquidity proxy. We derive daily distributions of illiquidity contributions to the credit spread at the individual bond level and find that liquidity premia were close to zero just before the financial crisis. We observe the time-varying nature of liquidity premia as well as a widening in the daily distribution in the years after the credit crunch. We find evidence to support higher liquidity premia, on average, on bonds of lower credit quality. The evolution of model parameters is economically intuitive and brings additional insight into investors’ behaviour. The frequent and bond-level estimation of liquidity premia, combined with few data restrictions makes the approach suitable for ALM modelling, especially when future work is directed towards arriving at forward-looking estimates at both the aggregate and bond-specific level.

Keywords

Liquidity premiumCorporate bondsCredit spreadBid-ask spread

JEL classification

G22: Insurance • Insurance Companies • Actuarial Studies G24: Investment Banking • Venture Capital • Brokerage • Ratings and Ratings Agencies G12: Asset Pricing • Trading Volume • Bond Interest Rates
Type
Papers
Information
Annals of Actuarial Science , Volume 9 , Issue 2 , September 2015 , pp. 264 - 289
Copyright
© Institute and Faculty of Actuaries 2015 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Acerbi, C. & Scandolo, G. (2008). Liquidity risk theory and coherent measures of risk. Quantitative Finance, 8, 681–692.Google Scholar
Amihud, Y. (2002). Illiquidity and stock returns: cross-section and time-series effects. Journal of Financial Markets, 5, 31–56.Google Scholar
Amihud, Y. & Mendelson, H. (1986). Asset pricing and the bid-ask spread. Journal of Financial Economics, 17, 223–249.Google Scholar
Amihud, Y., Mendelson, H. & Pedersen, L.H. (2006). Liquidity and Asset Prices. Now Publishers Inc., Hanover, MA, USA.Google Scholar
Arora, N., Gandhi, P. & Longstaff, F.A. (2012). Counterparty credit risk and the credit default swap market. Journal of Financial Economics, 103, 280–293.Google Scholar
Bao, J., Pan, J. & Wang, J. (2011). The illiquidity of corporate bonds. The Journal of Finance, 66, 911–946.Google Scholar
Bharath, S.T. & Shumway, T. (2008). Forecasting default with the Merton distance to default model. Review of Financial Studies, 21, 1339–1369.Google Scholar
Black, F. & Cox, J.C. (1976). Valuing corporate securities: some effects of bond indenture provisions. The Journal of Finance, 31, 351–367.CrossRefGoogle Scholar
Bongaerts, D., De Jong, F. & Driessen, J. (2011). Derivative pricing with liquidity risk: theory and evidence from the credit default swap market. The Journal of Finance, 66, 203–240.Google Scholar
Breger, L. & Stovel, D. (2004). Agency ratings in the Pfandbrief market. The Journal of Portfolio Management, 30, 239–243.Google Scholar
Brennan, M., Huh, S.-W. & Subrahmanyam, A. (2013). An analysis of the Amihud illiquidity premium. Review of Asset Pricing Studies, 3, 133–176.CrossRefGoogle Scholar
Brennan, M.J., Chordia, T., Subrahmanyam, A. & Tong, Q. (2012). Sell-order liquidity and the cross-section of expected stock returns. Journal of Financial Economics, 105, 523–541.Google Scholar
Brigo, D., Predescu, M., Capponi, A., Bielecki, T.R. & Patras, F. (2011). Liquidity modeling for credit default swaps: an overview. Credit Risk Frontiers: Sub-Prime Crisis, Pricing and Hedging, CVA, MBS, Ratings, and Liquidity, pp. 585–617, John Wiley & Sons, Hoboken, New Jersey.Google Scholar
Brunnermeier, M.K. & Pedersen, L.H. (2009). Market liquidity and funding liquidity. Review of Financial Studies, 22, 2201–2238.Google Scholar
Chen, L., Lesmond, D.A. & Wei, J. (2007). Corporate yield spreads and bond liquidity. The Journal of Finance, 62, 119–149.Google Scholar
Credit Suisse Group (2009). Understanding the negative basis, technical report, Credit Suisse Research and Analytics, Zürich, Switzerland.Google Scholar
Cochrane, J.H. (2005). Asset Pricing, vol. 1. Princeton University Press, Princeton, NJ.Google Scholar
Collin-Dufresne, P., Goldstein, R.S. & Martin, J.S. (2001). The determinants of credit spread changes. The Journal of Finance, 56, 2177–2207.Google Scholar
Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). (2010). Task force on the illiquidity premium: report, technical report, CEIOPS, Frankfurt, Germany.Google Scholar
Dastidar, S.G. & Phelps, B.D. (2011). Credit spread decomposition: decomposing bond-level credit OAS into default and liquidity components. The Journal of Portfolio Management, 37, 70–84.Google Scholar
De Jong, F. & Driessen, J. (2012). Liquidity risk premia in corporate bond markets. The Quarterly Journal of Finance, 2, 1250006, doi:10.1142/S2010139212500061.Google Scholar
Dick-Nielsen, J. (2009). Liquidity biases in trace. The Journal of Fixed Income, 19, 43–55.Google Scholar
Dick-Nielsen, J., Feldhütter, P. & Lando, D. (2012). Corporate bond liquidity before and after the onset of the subprime crisis. Journal of Financial Economics, 103, 471–492.CrossRefGoogle Scholar
Duffie, D. & Singleton, K.J. (1999). Modeling term structures of defaultable bonds. Review of Financial studies, 12, 687–720. Soc Financial Studies.Google Scholar
Edwards, A.K., Harris, L.E. & Piwowar, M.S. (2007). Corporate bond market transaction costs and transparency. The Journal of Finance, 62, 1421–1451.Google Scholar
Eom, Y.H., Helwege, J. & Huang, J. (2004). Structural models of corporate bond pricing: an empirical analysis. Review of Financial Studies, 17, 499–544.Google Scholar
Fan, H. & Sundaresan, S.M. (2000). Debt valuation, renegotiation, and optimal dividend policy. Review of Financial Studies, 13, 1057–1099.Google Scholar
Feldhütter, P. (2012). The same bond at different prices: identifying search frictions and selling pressures. Review of Financial Studies, 25, 1155–1206.CrossRefGoogle Scholar
Friewald, N., Jankowitsch, R. & Subrahmanyam, M.G. (2012). Illiquidity or credit deterioration: a study of liquidity in the US corporate bond market during financial crises. Journal of Financial Economics, 105, 18–36.Google Scholar
Geske, R. (1977). The valuation of corporate liabilities as compound options. Journal of Financial and Quantitative Analysis, 12, 541–552.CrossRefGoogle Scholar
Han, S. & Zhou, H. (2008). Effects of liquidity on the nondefault component of corporate yield spreads: evidence from intraday transactions data, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington DC, USA.Google Scholar
Houweling, P., Mentink, A. & Vorst, T. (2005). Comparing possible proxies of corporate bond liquidity. Journal of Banking & Finance, 29, 1331–1358.Google Scholar
Jones, E.P., Mason, S.P. & Rosenfeld, E. (1984). Contingent claims analysis of corporate capital structures: an empirical investigation. The Journal of Finance, 39, 611–625.Google Scholar
Kerry, W. (2008). Measuring financial market liquidity. Journal of Risk Management in Financial Institutions, 1, 181–190.Google Scholar
Koziol, C. & Sauerbier, P. (2007). Valuation of bond illiquidity: an option-theoretical approach. The Journal of Fixed Income, 16, 81–107.CrossRefGoogle Scholar
Kyle, A.S. (1985). Continuous auctions and insider trading. Econometrica: Journal of the Econometric Society, 53, 1315–1335.Google Scholar
Leland, H.E. (1994). Corporate debt value, bond covenants, and optimal capital structure. The Journal of Finance, 49, 1213–1252.Google Scholar
Leland, H.E. & Toft, K.B. (1996). Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads. The Journal of Finance, 51, 987–1019.Google Scholar
Longstaff, F.A., Mithal, S. & Neis, E. (2005). Corporate yield spreads: default risk or liquidity? New evidence from the credit default swap market. The Journal of Finance, 60, 2213–2253.Google Scholar
Longstaff, F.A. & Schwartz, E.S. (1995). A simple approach to valuing risky fixed and floating rate debt. The Journal of Finance, 50, 789–819.CrossRefGoogle Scholar
Markit (2008). Markit iBoxx EUR/GBP bond price consolidation rules, technical report, Markit Group Limited, London, UK.Google Scholar
Markit (2012 a). Markit iBoxx GBP benchmark index, technical report, Markit Group Limited, London, UK.Google Scholar
Markit (2012 b). Markit iBoxx rating methodology, technical report, Markit Group Limited, London, UK.Google Scholar
Markit (2014). Markit iBoxx bond index calculus, technical report, Markit Group Limited, London, UK.Google Scholar
Merton, R.C. (1974). On the pricing of corporate debt: the risk structure of interest rates. The Journal of Finance, 29, 449–470.Google Scholar
Roll, R. (1984). A simple implicit measure of the effective bid-ask spread in an efficient market. The Journal of Finance, 39, 1127–1139.Google Scholar
Sharpe, W.F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. The Journal of Finance, 19, 425–442.Google Scholar
Webber, L. (2007). Decomposing corporate bond spreads. Bank of England Quarterly Bulletin, 47, 533–541.Google Scholar
Zhou, C. (2001). The term structure of credit spreads with jump risk. Journal of Banking & Finance, 25, 2015–2040.Google Scholar