An Asset Pricing Approach to Liquidity Effects in Corporate Bond Markets

Abstract

We use an asset pricing approach to compare the effects of the liquidity level and liquidity risk on expected U.S. corporate bond returns. Using signed transaction data, we estimate effective transaction costs for bond portfolios by a repeat-sales method. We find that the liquidity level and exposure to equity market liquidity risk affect expected bond returns. In contrast, exposure to corporate bond liquidity shocks carries an economically negligible risk premium. A simulation study shows that it is unlikely that our results are driven by measurement error in betas or multicollinearity. We present a simple theoretical model that explains these findings. Received September 24, 2013; editorial decision September 23, 2016 by Editor Geert Bekaert.