State-varying illiquidity risk in sovereign bond spreads

Illiquidity and default risk are determinants of bond spreads that models suggest vary across market states. The Australian sovereign debt market, where the Australian government provided an explicit guarantee over semi-government debt, provides an environment in which to examine these separate factors. We find little evidence that the factors proposed by reduced-form models can explain sovereign spreads, while, consistent with flights to liquidity, illiquidity risk is relevant particularly important during periods of market stress. These flights to liquidity are substantially more prominent at the shorter end of the term structure, whereas volatility predominantly explains longer-maturity sovereign spreads. The term spread of sovereign yields is shown to be negatively related to illiquidity during periods of stress, indicating that theoretical models that incorporate flights to liquidity need to be expanded to include the impact of such flights on both the level and slope of yields.