A Conditional Analysis of Liquidity on Quality in the U.S. Corporate Bond Universe

Abstract: Why are high-yield bonds more severely hit by large liquidity dry outs than investment grade bonds? This study investigates the effects of liquidity shocks on returns in the U.S. corporate bond market during times of heightened liquidity stress, using a comprehensive data set of 13,500 bonds between October 2004 and September 2013. Applying a Markov regime-switching model,we identify liquidity stress periods in which illiquid bonds underperform by as much as 21.7% relative to their liquid counterparts in the high-yield segment, while the same return differential amounts to only 5.4% for investment grade bonds. We show that classical explanatory approaches fail to describe these differing effects on returns: neither the pre-crisis liquidity levels nor the liquidity shocks during the stress periods show an asymmetric distribution across ratings. Thus, a puzzling aspect of investors' behavior can be inferred: during times of distress, investors punish the same unit of illiquidity differently across credit quality. In order to explain this phenomenon, we develop a model in non-formal reasoning. It is grounded on the idea that investors perceive liquidity dry outs as transitory and therefore only penalize assets that are likely to be sold in the short-term. Since investors are more risk-averse in times of distress, high-yield bonds are the first of the investors' assets in line to be liquidated, and thus investment grade bonds only show marginal return effects with respect to liquidity shocks, perceived to be of temporary nature.