Understanding Corporate Bond Liquidity and Yield Spreads

A corporate bond’s liquidity plays a crucial role in determining how easily large asset trades can be made without affecting its price. The link between bond liquidity and yield spread has been the focus of several studies, including Market Liquidity and Trading Activity and The Illiquidity of Corporate Bonds.

Systematic Liquidity in the Corporate Bond Market

Research highlights a clear connection between systematic liquidity risk (also known as common liquidity risk) and the pricing of corporate bonds. Liquidity issues can significantly influence yield spreads, especially during periods of market instability when spreads tend to widen dramatically.

Corporate bond liquidity tends to fluctuate, particularly during economic uncertainty. However, how different classes of bonds respond to liquidity shocks varies depending on their credit ratings. While AAA bonds tend to perform better, lower-rated, higher-yield bonds often struggle. In stable markets, bond liquidity is typically influenced by factors specific to each issuer.

Idiosyncratic Liquidity in Corporate Bonds

Heck et al. identified a significant relationship between bond yield spreads and specific, or idiosyncratic, liquidity issues. Their study found that certain corporate bonds may exhibit illiquidity due to the nature of the market. Investors may avoid these bonds either because they are unaware of them or are restricted from investing in them.

Retail investors, in particular, may struggle to invest in high-denomination corporate bonds, which often require a minimum investment of $100,000 or more. This high entry point makes it challenging for smaller investors to include these bonds in their diversified portfolios.

Heck’s research also revealed that shorter-term and higher-yield bonds tend to be more vulnerable to idiosyncratic illiquidity. This is particularly noticeable in the case of junk bonds, which are most affected by liquidity issues.

Key Takeaways

• Liquidity significantly affects corporate bond yield spreads, with a greater impact during market volatility.
• Higher-yield, lower-rated bonds are more susceptible to liquidity shocks than AAA-rated bonds.
• Retail investors often face barriers to investing in high-denomination corporate bonds.
• Idiosyncratic liquidity issues are more pronounced in shorter-term and higher-yield bonds, especially junk bonds.

Conclusion

Research shows that illiquidity plays a key role in determining corporate bond yields. Liquidity risk is an important factor that should be closely monitored by both private and institutional investors. Due to the complexity of liquidity risk, professional analysis is essential for a deeper understanding.