Bridge over ocean
1 April 2017 CFA Institute Journal Review

The Pricing of Different Dimensions of Liquidity: Evidence from Government Guaranteed Bonds (Digest Summary)

  1. Stuart Fujiyama, CFA

During the 2008 financial crisis, the Federal Deposit Insurance Corporation’s Debt Guarantee Program provided crucial government backing for bank-issued bonds, creating a special set of corporate bonds with the same default risk as that of US Treasuries. Today, those bonds are providing researchers with insights into how different dimensions of liquidity affect the pricing of corporate bonds.

How Is This Research Useful to Practitioners?

A special set of corporate bonds arose from the financial crisis and the Debt Guarantee Program (DGP) of the Federal Deposit Insurance Corporation (FDIC). The FDIC insured bank debt against default with the full faith and credit of the US government, resulting in AAA ratings for each of the guaranteed bond issuances. Subtracting the yields of Treasury debt from the yields of these insured bonds provides the authors with the implied nondefault component of the yield spread of corporate debt.
The DGP ran from 2008 through 2012. Over that period, the total (default + nondefault) yield spreads of Aaa and Baa industrial bonds were about 90 bps and 232 bps, respectively. For the DGP bonds, the authors find an average nondefault spread of around 21 bps, which can be attributed to three dimensions of liquidity: 80% from the trading costs, 17% from resiliency, and 3% from depth.
The authors examine bond-specific and marketwide trading costs, resiliency, and depth. They find that for the overall 2008–12 period and the 2010–12 post-crisis period, all three bond-specific liquidity dimensions and all three marketwide liquidity dimensions have a significant impact on nondefault spreads. For the 2008–09 crisis period, however, marketwide trading costs, bond-specific resiliency, and bond-specific trading costs are the only dimensions that have a significant impact.
After controlling for state taxes and the three dimensions of liquidity, the authors find that the residual nondefault spread is zero for the overall period. They also conduct an exploratory analysis, which indicates that the nondefault spread for the two subperiods—especially the crisis period—may include a small additional “flight-to-extreme-liquidity” premium, reflecting the fear of future volatility.

How Did the Authors Conduct This Research?

The authors obtain transaction-level data from the Trade Reporting and Compliance Engine enhanced dataset and bond-level data from the Mergent Fixed Investment Securities Database. Combining the two data extracts by the Committee on Uniform Securities Identification Procedures (CUSIP), the authors apply filters and calculate nondefault spreads. They merge the resulting dataset with measures of three dimensions of liquidity—trading costs, depth, and resiliency—resulting in 10,122 bond-day observations over 2008–2012.
Using bid–ask spreads, the authors measure bond-specific trading costs. They measure depth using the Amihud (Journal of Financial Markets 2002) illiquidity measure, which captures the price impact of trades, and they measure resiliency using a new model of the mean reversion of aggregate over-the-counter dealer inventories. Using information from GovPX, they construct corresponding marketwide trading cost, depth, and resiliency indexes on the basis of the liquidity of Treasuries.
To examine whether the three liquidity dimensions, both bond specific and marketwide, are priced factors in the nondefault spread of DGP bonds, the authors use multivariate analysis (robust standard errors clustered by bond and date). They use bond fixed effects to isolate the impact of changes in liquidity on nondefault spreads.
To test for robustness, the authors empirically examine whether causality in the relationship between liquidity and nondefault spreads runs in the expected direction: Higher (lower) liquidity leads to lower (higher) nondefault spreads.

Abstractor’s Viewpoint

The authors discuss the merits of their study primarily in terms of refinements to previous methodologies—for example, the ability to cleanly separate nondefault spreads from default spreads.
They also help inform post-crisis discussions about corporate bond liquidity. Given current capital and liquidity regulations, banks are no longer engaging in the liquidity-providing market-making activities that they once did. Although liquidity-driven nondefault spreads are clearly smaller than even AAA default spreads during the 2008–12 measurement period, that may not be true going forward. The authors thus provide some insight into the changes in yield that are likely to occur should we happen to enter a severely negative environment for corporate bonds in the near future.
A cursory review of financial media coverage of corporate bond liquidity reveals the efforts of many fixed-income portfolio managers to highlight the associated risks for the benefit of retail investors and financial professionals (e.g., corporate treasurers). This article should be helpful to those portfolio managers, not only in their primary duties but also in formulating specific and meaningful words of caution for the investing public.

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