Realized Volatility, Liquidity, and Corporate Yield Spreads

I propose a bond-specific, time-varying friction measure of round-trip liquidity costs. The measure is robust to outliers in daily bond returns and accounts for the idiosyncratic information behind bond trading decisions. Using transactions from January 2004 to December 2010, I find that liquidity costs display a strong correlation with credit conditions and peaked during the sub-prime crisis. The proposed measure also captures a smaller spike in liquidity costs for speculative-grade bonds during the Ford/GM crisis of 2005. High-frequency measures of volatility alone explain about 50% of the variation of yield spreads. After controlling for equity volatility, liquidity costs still explain a substantial fraction of the variation in the yield spreads of highly rated bonds. The properties of the proposed model are valuable in dealing with the credit risk puzzle, which pertains mainly to the investment-grade universe.