Liquidity and Credit Risk

Abstract

We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years, we find evidence of a positive correlation between the illiquidity and default components of yield spreads as well as support for downward-sloping term structures of liquidity spreads. Copyright 2006 by The American Finance Association.

Determinants of yield spread dynamics: Euro versus US dollar corporate bonds

“…The results in Table 5 tell us that yield spreads are primarily and significantly affected by changes in the bid-ask spread in an environment of high liquidity risk. Similar to Ericsson and Renault (2006), the results present a strong negative dependence of the effect of the bid-ask spread upon credit quality. For example, a 10 basis points increase in the bid-ask spread during a period of high liquidity risk causes a 2 basis points increase in US dollar AA-rated bond spreads and a 20 basis points increase in BBB-rated bond spreads.…”

“…The adjusted R 2 of the model including all explanatory variables is presented in the final column. Similar to Ericsson and Renault (2006), I find strong evidence of autocorrelation in yield spread changes. To capture the autocorrelation, a fixed-effects model with AR(1) error terms is used.…”

Accounting quality, debt covenant design, and the cost of debt

“…Moreover, considering the importance of debt covenants in alleviating adverse information problems, such as mitigating agency conflicts and reducing estimation risk on borrowers' future cash flows (Jensen and Meckling 1976;Myers 1977;Smith and Warner 1979;Leland 1998;Douglas et al 2014), we examine whether the presence of a ''strict'' 1 Issuing corporate bonds and borrowing from the bank are the two most important ways a firm receives debt financing. The public bond market is less liquid than the equity market while banks rely heavily on private information when making lending decisions (Diamond 1991;Ericsson and Renault 2006;Bharath et al 2011;Liu and Magnan 2014). This largely limits the role of public accounting information in the debt market.…”

An empirical analysis of alternative recovery risk models and implied recovery rates

“…See, among others, the insights inBakshi et al (2006,Cremers et al (2004),Duffee (1999),Duffie and Singleton (1997),Elton et al (2001),Ericsson et al (2004),Ericsson and Renault (2005), He(2000),Janosi et al (2002),Liu et al (2006),Longstaff et al (2005),Pan and Singleton (2005), andZhu et al (2005). The Duffie-Singleton framework has become an integral part of credit risk related research.…”