Liquidity Risk Premia in Corporate Bond Markets∗

This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that corporate bond returns have significant exposures to fluctuations in treasury bond liquidity and equity market liquidity. Further, this liquidity risk is a priced factor for the expected returns on corporate bonds, and the associated liquidity risk premia help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.6% per annum for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1.5% per annum. We find very similar evidence for the liquidity risk exposure of corporate bonds for a sample of European corporate bond prices. ∗We are grateful to Inquire Europe for financial support. We thank Viral Acharya, Michael Fleming, Nicolae Gârleanu, Ludovic Phalippou and Marti Subrahmanyam for comments on earlier drafts, as well as seminar participants at NYU-Moody’s Credit Conference 2006, the 2006 CEPR Gerzensee meeting, London School of Economics, Oslo Norwegian School of Management, and University of Bergen. Correspondence address: Frank de Jong, Finance Department, Tilburg University, P.O. Box 90153, 5000 LE, Tilburg, Netherlands. Phone: +31-12-4668040; Fax: +31-13-4662875 E-mail: [email protected]. Joost Driessen, Finance Group, Faculty of Economics and Econometrics, University of Amsterdam. Roetersstraat 11, 1018 WB, Amsterdam, the Netherlands. E-mail: [email protected]. Liquidity Risk Premia in Corporate Bond Markets