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Endogenous liquidity and defaultable bonds

Author

Listed:
  • Konstantin Milbradt

    (MIT)

  • Zhiguo He

    (University of Chicago)

Abstract

This paper studies the liquidity of defaultable corporate bonds that are traded in an over- the-counter secondary market with search frictions. Bargaining with dealers determines a bond’s endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default and investment decisions interact with the endogenous secondary market liquidity via the rollover channel. A default/investment-liquidity loop arises: Earlier endogenous default worsens a bond’s secondary market liquidity, which amplifies equity holders’ rollover losses, which in turn leads to earlier endogenous default. Thus, our model characterizes the full inter-dependence between liquidity premium and default premium in understanding credit spreads for corporate bonds. We also study the optimal maturity implied by the model, and an extension where worsening secondary market liquidity feeds back to endogenous under- investment.

Suggested Citation

  • Konstantin Milbradt & Zhiguo He, 2012. "Endogenous liquidity and defaultable bonds," 2012 Meeting Papers 86, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:86
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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