This paper examines the illiquidity of corporate bonds and its asset-pricing implications.Using transaction-level data from 2003 through 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bidask spreads. We establish a strong link between bond illiquidity and bond prices, both in aggregate and in the cross-section. In aggregate, changes in the market level illiquidity explain a substantial part of the time variation in yield spreads of high-rated (AAA through A) bonds, over-shadowing the credit risk component. In the cross-section, the bond-level illiquidity measure explains individual bond yield spreads with large economic significance. * Bao is from Ohio State University, Fisher College of Business (bao 40@fisher.osu.edu); Pan is from MIT Sloan School of Management, CAFR and NBER (junpan@mit.edu); and Wang is from MIT Sloan School of Management, CAFR and NBER (wangj@mit.edu). The authors thank Campbell Harvey (the editor), the associate editor, two anonymous reviewers, Andrew Lo, Ananth Madhavan, Ken Singleton, Kumar Venkataraman (WFA discussant) The illiquidity of the US corporate bond market has captured the interest and attention of researchers, practitioners and policy makers alike. The fact that illiquidity is important in the pricing of corporate bonds is widely recognized, but the evidence is mostly qualitative and indirect. In particular, our understanding remains limited with respect to the relative importance of illiquidity and credit risk in determining corporate bond spreads and how their importance varies with market conditions. The financial crisis of 2008 has brought renewed interest and a sense of urgency to this topic when concerns over both illiquidity and credit risk intensified at the same time and it was not clear which one was the dominating force in driving up the corporate bond spreads.The main objective of this paper is to provide a direct assessment on the pricing impact of illiquidity in corporate bonds, at both the individual bond level and the aggregate level.Recognizing that a sensible measure of illiquidity is essential to such a task, we first use transaction-level data of corporate bonds to construct a simple and yet robust measure of illiquidity, γ, for each individual bond. Aggregating this measure of illiquidity across individual bonds, we find a substantial level of commonality. In particular, the aggregate illiquidity comoves in an important way with the aggregate market condition, including market risk as Using the aggregate γ measure for corporate bonds, we set out to examine the relative importance of illiquidity and credit risk in explaining the time variation of aggregate bond spreads. We find that illiquidity is by far the most important factor in explaining the monthly changes in the US aggregate yield spreads of high-rated bonds (AAA through A), with an R-squared ranging from 47% to 60%. Adding an aggregate CDS index as a proxy for aggregate 1 credit risk, we find that it also plays an...

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Focusing on downgrades as stress events that drive the selling of corporate bonds, we document that the illiquidity of stressed bonds has increased after the Volcker Rule. Dealers regulated by the Rule have decreased their market-making activities while non-Volcker-affected dealers have stepped in to provide some additional liquidity. Furthermore, even Volcker-affected dealers that are not constrained by Basel III and CCAR regulations change their behavior, inconsistent with the effects being driven by these other regulations. Since Volcker-affected dealers have been the main liquidity providers, the net effect is that bonds are less liquid during times of stress due to the Volcker Rule.