Title

Liquidity, taxes and credit risk of fixed income securities

Date of Award

2004

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Business Administration

Advisor(s)

Chunchi Wu

Keywords

Liquidity, Taxes, Credit risk, Fixed income securities

Subject Categories

Business | Business Administration, Management, and Operations | Finance and Financial Management

Abstract

Liquidity risk has been thought to be an important factor affecting bond pricing. However, measuring and tracking liquidity spreads remains an elusive task. One of the major obstacles is that liquidity risk is often confounded with effects of other factors which are often difficult to disentangle empirically. This dissertation first examines the liquidity of off-the-run Treasury securities relative to that of on-the-run issues and its effect on the pricing of these securities. The difference in the liquidity of on- and off-the-run issues is modeled as an intensity process in a reduced form model. The liquidity intensity process is then estimated for Treasury issues that were off the run over various length of period. The model provides a convenient framework for tracking Treasury market liquidity. Results show that liquidity spreads are positively related to the length of the off-the-run period. Moreover, liquidity spreads of off-the-run issues increase with bond maturity. The liquidity spread of corporate straight bonds is higher than that of the Treasury securities and tends to increases with lower credit ratings. In addition, the premium associated with liquidity risk in junk bonds contributes significantly more to the total yield spread than that in investment-grade bonds. The regression of liquidity spreads over various measures shows that bid-ask spread and trading depth are useful in measuring the liquidity premium of Treasury bonds.

Empirical studies have shown that existing term structure models cannot fully explain yield spreads of corporate bonds. An issue of particular concern is that taxes have been ignored in modern term structure models. In the second part of this dissertation, I directly estimate the default premium from the risk-neutral model by explicitly accounting for the tax effect and the term structure of interest rates. This approach contrasts with previous studies that rely on either the data published by rating agencies or empirical probabilities to estimate the default premium. It is found that the term structure model explains corporate bond yields very well. Contrary to previous findings, the results show that default risk and taxes explain a high percentage of corporate bond yield spreads.

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