Realized Volatility, Liquidity, and Corporate Yield Spreads
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abstract
I propose a friction measure of bond round-trip liquidity costs that is robust to outliers and accounts for the idiosyncratic information behind trading decisions. Particularly effective with investment-grade bonds, the proposed measure displays properties consistent with the credit risk puzzle. Using transactions from January 2004 to December 2011, I find that liquidity costs display a strong correlation with credit conditions and peaked during the sub-prime crisis. After controlling for equity volatility with high-frequency measures, liquidity costs explain a substantial fraction of the variation in the yield spreads of highly rated bonds, but become less important for speculative-grade bonds.
