Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle

We develop a structural credit model to examine how interactions between default and liquidity affect corporate bond pricing. The model features debt rollover and bond-price-dependent holding costs. Over the business cycle and in the cross-section, the model matches average default rates and credit spreads in the data, and captures variations in bid-ask and bond-CDS spreads. A structural decomposition reveals that default-liquidity interactions can account for 10%-24% of the level of credit spreads and 16%-46% of the changes in spreads over the business cycle. Further, liquidity-related corporate bond financing costs amount to 6% of the total issuance amount from 1996 to 2015.