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Solving the Credit Spread Puzzle

3/7/2007 --

A new mathematical model helps to explain the role of liquidity in pricing Treasury notes and corporate bonds.

ANN ARBOR, Mich.—Securities investors typically require a higher yield for bonds with lower liquidity, due to concerns they may be forced to sell at a drastically reduced price when liquidity is low or to pay excessively high transaction costs to trade.

This so-called liquidity premium is considered to be an important factor affecting bond pricing. However, the task of measuring and tracking the “liquidity effect” on corporate bond pricing has proven to be elusive, because default and market risks also impact pricing and are difficult to disentangle.

A new study by Haitao Li, assistant professor of finance at the Ross School of Business, investigates the role of liquidity in the pricing of fixed-income securities and develops a two-stage mathematical model that can be used for estimating the liquidity spread of corporate bonds.

“Existing models of defaultable bonds have failed to explain corporate bond yield spreads satisfactorily,” Li said. “In practice, most of these models have consistently underestimated the yield spreads, a perplexing problem widely known as the credit spread puzzle.

"The factor that seems to be missing in these calculations is liquidity. However, measuring the liquidity component of corporate yield spread is complicated because it is inherently difficult to separate the liquidity premium from the default premium.”

To accomplish this, Li and colleagues Jian Shi of Marshall University and Chunchi Wu of Singapore Management University use the spread information from on- and off-the-run Treasuries to retrieve a “market-wide liquidity factor.”

On-the-run Treasuries are the most recently issued and frequently traded bonds or notes of a particular maturity and, therefore, the most liquid. They typically cost more and yield less than their off-the-run counterparts, which are older issues and traded more infrequently. By incorporating this liquidity factor into their formulation for defaultable corporate bonds, the researchers are able to estimate the liquidity spread.

“Liquidity in Treasury markets affects the pricing of virtually every other asset in financial markets, and this intermarket relation is much stronger between corporate and Treasury securities,” Li said. “Thus, by including the liquidity condition of the Treasury bond market as a factor in our pricing model of defaultable bonds, we are better able to capture bond pricing variations and to estimate corporate bond liquidity spread.”

In their analysis, the researchers find that the liquidity factor is strongly related to conventional liquidity measures, such as bid-ask spread, volume, order imbalance and depth. To test their proposed pricing model, they obtain securities data from Lehman Brothers for corporate bonds issued from January 1993 to December 1996 and from January 1997 to December 2002.

Their results show that the liquidity spread is higher for corporate bonds compared to off-the-run Treasuries. Furthermore, the researchers say, the magnitude of the liquidity premium is sizeable and increases with maturity and credit risk. On average, the liquidity spread accounts for close to 30 percent of the spread of corporate bonds in the whole sample, 24 percent of the spread for investment-grade bonds and about a third of the spread for speculative-grade bonds.

“The liquidity effect on corporate bond pricing is significant, therefore including the liquidity premium in our model should help to explain the credit spread puzzle,” Li said.

Written by Claudia Capos



For more information, contact:
Bernie DeGroat
Phone: (734) 936-1015 or 647-1847
E-mail: bernied@umich.edu