Feedback Between Credit And Liquidity Risk In The Us Corporate Bond Market

We analyze the dynamic interactions between credit and liquidity risk and their impact on bond prices and risk. We propose a novel way of modeling credit-liquidity interactions through mutually exciting processes and develop a corresponding Bayesian estimation procedure. Using US corporate bond transaction data, we show that there is evidence of feedback between credit and liquidity risk and that this feedback is stronger for lower-rated bonds. We find that, on average, the credit-induced liquidity component accounts for 8% (AAA/AA) to 17% (B and lower) of total yield spreads, but in the most distressed periods it can account for over 40%.