a b s t r a c tWe analyze liquidity components of corporate bond spreads during 2005-2009 using a new robust illiquidity measure. The spread contribution from illiquidity increases dramatically with the onset of the subprime crisis. The increase is slow and persistent for investment grade bonds while the effect is stronger but more short-lived for speculative grade bonds. Bonds become less liquid when financial distress hits a lead underwriter and the liquidity of bonds issued by financial firms dries up under crises. During the subprime crisis, flight-to-quality is confined to AAA-rated bonds.

We analyze liquidity components of corporate bond spreads during 2005-2009 using a new robust illiquidity measure. The spread contribution from illiquidity increases dramatically with the onset of the subprime crisis. The increase is slow and persistent for investment grade bonds while the effect is stronger but more short-lived for speculative grade bonds. Bonds become less liquid when financial distress hits a lead underwriter and the liquidity of bonds issued by financial firms dries up under crises. During the subprime crisis, flight-to-quality is confined to AAA-rated bonds.

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I model how corporate bond prices are affected by search frictions and occasional selling pressures and test my predictions empirically. A key prediction is that in a distressed market with more sellers than buyers, prices paid by institutional investors decrease more than those of retail investors. Using a structural estimation, the model is able to identify liquidity crises (i.e. high number of forced sellers) based on the relative prices of institutional and retail investors. New light is shed on two crises, the downgrade of GM and Ford in 2005 and the current crisis. The model also explains why the spread between corporate bond yields and Treasury yields is so large, the so-called credit spread puzzle. * I am very grateful to David Lando and Lasse Heje Pedersen for many helpful comments and discussions and to Jens Dick-Nielsen for discussions regarding the TRACE database. I also thank Viral

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a b s t r a c tWe analyze liquidity components of corporate bond spreads during 2005-2009 using a new robust illiquidity measure. The spread contribution from illiquidity increases dramatically with the onset of the subprime crisis. The increase is slow and persistent for investment grade bonds while the effect is stronger but more short-lived for speculative grade bonds. Bonds become less liquid when financial distress hits a lead underwriter and the liquidity of bonds issued by financial firms dries up under crises. During the subprime crisis, flight-to-quality is confined to AAA-rated bonds.

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