Latent Liquidity and Corporate Bond Yield Spreads

Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their riskless benchmarks. One candidate for the unexplained portion of the spread is a premium for the illiquidity in the corporate bond market. We investigate this issue by relating the liquidity of corporate bonds, as measured by their ease of market access, to the non-default component of their respective corporate bond yields using the portfolio holdings database of the largest custodian in the market. The ease of access of a bond is measured using a recently developed measure called latent liquidity that weights the turnover of funds holding the bond by their fractional holdings of the bond. We use the credit default swap (CDS) prices of the bond issuer to control for the credit risk of a bond. At an aggregate level, we find a contemporaneous relationship between aggregate latent liquidity and the average non-default component in corporate bond yields. Additionally, for individual bonds, we find that bonds with higher latent liquidity have a lower non-default component of their yield spread. We also document that bonds that are held by funds that exhibit greater buying activity command lower spreads (i.e., are more expensive), while the opposite is true for those that exhibit greater selling activity. We also find that the liquidity in the CDS market has an impact on bond pricing, over and above bond-specific liquidity effects. JEL Classification: G100 (General Financial Markets) We acknowledge the generous support of State Street Corporation in providing the resources for conducting the research reported in this paper. We thank Craig Emrick, Sriketan Mahanti, Gaurav Mallik, Jeffrey Sutthoff and Caroline Shi at State Street Corporation for helpful discussions and their unstinting support in putting together the databases used in this research. We thank George Chacko and Lasse Pedersen for suggestions regarding the research design and comments on a previous version of the paper. We also thank Mike Piwowar and participants at the NBER conference on microstructure, and at the 6th Transatlantic Doctoral Conference at London Business School for their valuable suggestions. All errors remain our own. ∗email: [email protected]; Tel: +1 212 998 0718. Amrut Nashikkar is a PhD candidate at the Stern School of Business, New York University. †email: [email protected];Tel: +1 212 998 0348. Marti Subrahmanyam is at the Stern School of Business, New York University.