Realized Volatility, Liquidity, and Corporate

Yield Spreads
Marco Rossi

December 7, 2009
Abstract
This study revisits the relative role of credit risk and illiquidity as determinants of
corporate bond prices. Using TRACE transaction data from January 2003 to Decem-
ber 2008, I nd that high-frequency rm equity volatility measures explain 40% of the
variation of corporate yield spreads and as much as 52% of the variation in a multivari-
ate context. In contrast, trading-based illiquidity measures such as the percentage of
zero trading days, the friction measure used by Chen, Lesmond, and Wei (2007), and
a new measure derived in this paper explain approximately an incremental 1% of the
cross-sectional variation of yield spreads. Unlike other friction models, the proposed
model includes rm-specic factors in the return generating process and relaxes the
assumption of constant liquidity. As a result, liquidity cost estimates are lower and
uncorrelated with corporate yield spreads. Overall, my ndings suggest that credit
risk is the main determinant of corporate yield spreads and that certain trading-based
illiquidity measures actually capture credit risk.
Keywords: liquidity, credit risk, realized volatility, stochastic friction, TRACE.

Smeal College of Business, Department of Finance, Penn State University. Email: marco.rossi@psu.edu;
Phone: +1-814-865-2446. This paper has beneted enormously from discussions with Jingzhi Huang (com-
mittee chair) and Jean Helwege. I would also like to thank the other members of my committee, namely
Joel Vanden, William Kracaw, and John Liechty, as well as Jack Bao, Peter Ilev, Berardino Palazzo, Lukas
Roth, Robert Dittmar, Asher Curtis, Lubomir Petrasek, Xuemin (Sterling) Yan, Chunchi Wu, Kingsley
Fong, and seminar participants at Penn State, the University of Missouri, the University of Kansas, the
Bank of Canada, Seattle University, HEC Montreal, and the University of New South Wales for their helpful
comments and suggestions. This paper has beneted also from comments received at the FMA (2009) and
NFA(2009) conferences and at the FMA (2009) doctoral consortium.
Introduction
Structural credit risk models cannot adequately explain credit spread levels, credit spread
changes, and observed defaults.
1
On one hand, this empirical failure has prompted re-
searchers to reconsider the role of idiosyncratic volatility and jumps to better describe credit
risk. On the other hand, a growing number of studies argues that illiquidity might be an
additional determinant of corporate bond prices. However, in informationally ecient mar-
kets,
2
trading decisions are simultaneously aected by investors assessment of credit risk
(information side) and by the liquidity of the bond that they wish to trade (friction side).
In order to avoid attributing to illiquidity what is in fact credit risk, I propose a stochastic
friction model of corporate bond returns and liquidity developing the idea that, while system-
atic and idiosyncratic credit risk variables aect expected returns, bond returns are observed
only if there is enough valuable information to justify their liquidity costs. After obtaining
several trading-based liquidity measures, I conduct a cross-sectional regression analysis to
assess the relative importance of illiquidity and credit risk variables in the determination of
corporate yield spreads.
In recent applications of the standard friction model (Rosett (1959)) to stock and bond
liquidity, systematic factors summarize all the relevant information and liquidity is constant
(Lesmond, Ogden, and Trzcinka (1999), and Chen, Lesmond, and Wei (2007)). However,
these assumptions are quite restrictive given that the contingent claim approach to structural
credit risk modeling (e.g. Merton (1974)) assigns an important role to idiosyncratic variables
and given the evidence that corporate bond liquidity is time-varying.
I improve on the standard friction approach in several ways. First, I model bond returns
1
See Eom, Helwege, and Huang (2004) on spread levels, Collin-Dufresne, Goldstein, and Martin (2001)
on spread changes, and Huang and Huang (2003) on the credit spread puzzle, stating that credit risk model
cannot simultaneously explain observed defaults and average corporate yield spreads.
2
Hotchkiss and Ronen (2002) and Ronen and Zhou (2008) conclude that the US corporate bond market
is ecient.
2
as a function of individual factors such as equity returns and realized volatility. The use of
high frequency measures, such as realized volatility, is better able to identify jumps, which
carry more information than historical volatility estimated with daily data (see e.g. Huang
(2007)). Moreover, considering the relation between bond and equity returns of the same rm
allows for a hedging interpretation, rather than a linear asset pricing model interpretation
with all its caveats.
3
Next, I use a panel data approach to model liquidity as a function of bond characteristics
such as age and issue size
4
, whereas in previous friction models bond liquidity measures
were estimated individually as constant parameters. The shrinkage induced by the use of
a hierarchical panel approach has the additional benet of reducing the variance of the
estimated parameters of both the expected return and liquidity component of the model.
Lastly, I assume heteroscedastic shocks to bond returns. This last modeling approach
makes estimates robust to the presence of outliers, which are typical of tic-by-tic transaction
data (Brownlees and Gallo (2006)). The use of actual transaction data from TRACE is yet
another improvement on studies using Datastream or matrix price data.
5
The most important contribution of my study comes from the cross-sectional analysis of
corporate yield spreads and their determinants. Using bond transaction data in the period
from January 2003 to December 2008, I nd that credit risk variables account for a substan-
tial portion of the cross-sectional variation of credit spreads. In particular, individual realized
equity volatility measures have as much explanatory power as credit ratings. In contrast,
several trading-based liquidity measures have little explanatory power in a multivariate con-
text that adequately controls for credit risk. For instance, in univariate regressions the LOT
3
Schaefer and Strebulaev (2008) show that structural models can produce plausible hedge ratios even if
they cannot produce correct bond prices.
4
Alexander, Edwards, and Ferri (2000), and Hotchkiss and Jostova (2007) show that age and issue size
are among the main determinants of trading activity.
5
See Warga and Welch (1993) on the problems of using matrix-based data for studies involving corporate
bonds.
3
measure proposed by Chen, Lesmond, and Wei (2007) is positively associated with credit
spreads, but the strength of this relation goes down substantially once realized volatility is
included in the regression. This happens because rm equity realized volatility and the LOT
measure are signicantly positively correlated. This positive correlation is likely to indicate
that this liquidity measure might be capturing a form of mispricing associated to an omitted
variable (volatility) in the return generating process. Overall, this paper establishes the rst
order importance of credit risk, as opposed to illiquidity as proxied by certain trading-based
measures, in the determination of credit spreads.
My study has several other notable results. In a univariate analysis, I document that
trading activity is strongly aected by bond characteristics such as age, time to maturity, and
issue size. In particular, I show that small and short-maturity bonds trade very infrequently
relative to young and large issues. I corroborate these ndings with the friction model
estimates which show that round-trip liquidity costs are decreasing with issue size and time
to maturity, and increasing with age and the eurodollar-treasury (TED) spread, which is
meant to pick up ight-to-liquidity eects. Using year dummies to capture calendar time
eects, I nd that liquidity cost spiked in 2007 (credit-crisis) and went down again in 2008
without reaching, however, pre-crises levels.
The remainder of the paper is structured as follows. Section 1 presents a literature review.
Section 2 describes the derivation of the proposed illiquidity measure. Section 3 presents the
data. Section 4 applies the model to the data and presents estimation results. In section
5, I conduct a regression analysis of the determinants of corporate yield spreads. Section 6
concludes the study.
4
1 Related Literature
This paper relates to the study of Chen, Lesmond, and Wei (2007) who propose a limited
dependent variable (LDV) approach to derive a bond-specic measure of liquidity (also
known as the LOT measure). Applied on Datastream data, this liquidity measure explains
7% of the cross-sectional variation in yield spreads for investment grade bonds, and up to
22% of the variation for speculative grade bonds. The LDV approach posits the existence of a
linear model of bond returns which are observed only when they are beyond a threshold value.
These thresholds can be seen as an estimate of transaction costs. In the LOT measure, the
pricing factors are given by the daily change in the 10-year risk-free interest rate (systematic
bond factor), and the returns on the Standard & Poors 500 index (systematic equity factor).
The thresholds are simply two constants: one for negative returns (sell-side cost), and one
for positive returns (buy-side cost). However, being contingent claims on the rms assets,
debt and equity should depend on idiosyncratic as well as systematic factors. Furthermore,
there is evidence of substantial time variation in recently proposed liquidity measures (see
e.g. Longsta, Mithal, and Neis (2005), and Bao, Pan, and Wang (2008)).
My paper is also closely related to studies by Campbell and Taksler (2003) and Zhang,
Zhou, and Zhu (2009) who use equity and realized equity volatility measures to explain
credit and CDS spreads.
6
Campbell and Taksler (2003) nd that the correlation between
equity volatility and the spread of an index of A-rated bonds over treasuries is 0.7 in the
sample period from 1965 to 1999. Zhang, Zhou, and Zhu (2009) take this approach one step
further by using diusive and jump volatility measures from high frequency equity data as
explanatory variables in CDS spread regressions. They nd that volatility alone explains
roughly 50% of the variation in CDS spreads. I use the information from equity volatility
in two ways. First, similarly to Zhang, Zhou, and Zhu (2009), I extract equity jumps from
6
Goyal and Santa-Clara (2003) conclude that idiosyncratic risk matters, even in the context of corporate
bond pricing.
5
equity realized variance and use both jumps and the resulting diusive volatility as factors in
my bond return generating process. The idea is that jumps typically represent news entering
investors information sets and, therefore, are likely to be associated with trading activity in
the bond market. Second, given the documented importance of jumps,
7
I investigate which
component of equity volatility impacts credit spreads the most.
More generally, my study is related to a series of papers dealing with liquidity, credit
risk, and their interaction. Longsta, Mithal, and Neis (2005) use CDS data to extract the
default component of credit spreads and suggest that taxes and illiquidity in the bond mar-
ket explain the non-default component. Bao and Pan (2008) relate excess bond volatility (at
short horizons) to corporate bond liquidity. Bao, Pan, and Wang (2008) use the negative
of the auto-covariance of bond prices as a measure of liquidity. They document substantial
commonality across individual measures and correlation with market volatility (VIX). Ma-
hanti, Nashikkar, Subrahmanyam, Chacko, and Mallik (2008) propose a measure of liquidity
dened as the weighted average turnover of investors who hold a particular bond, where the
weights are the fractional holdings of the amount outstanding of the bond. The intuition
behind this measure is that investors with high turnover prefer to hold bonds with lower
transaction costs, and they further improve the liquidity of these bonds by trading them.
Finally, Ambrose, Cai, and Helwege (2008) and Ambrose, Cai, and Helwege (2009) consider
the confounding eects of credit risk and selling pressure for fallen angels, and argue that
most of the price variation taking place with a downgrade to junk status is due to credit risk
(information) rather than selling pressure (friction).
8
7
See also Tauchen and Zhou (2006), who show that the volatility of realized market jumps is able to
explain more than 60% of the variation of Moodys AAA and BAA credit spread monthly indices, and
Cremers, Driessen, and Maenhout (2008) on the importance of rm-specic jumps.
8
See also Driessen (2005), Houweling, Mentink, and Vorst (2003), and Kalimipalli and Nayak (2009).
6
2 Model
The idea of a friction model of liquidity is that while true returns depend on several stochastic
factors, observed returns will reect changes in the underlying factors only if the information
value of the marginal trader is sucient to cover the liquidity cost incurred upon trading
(Chen, Lesmond, and Wei (2007)). Unlike the LOT model, the empirical model that I pro-
pose allows for liquidity costs to vary over time,
9
with bond characteristics, and with macro
variables.
10
I also include a bond-specic eect to account for those eects not captured by
the variables included in the model. Another important dierence between my model and
the LOT model is that I use a hierarchical panel data approach to simultaneously estimate
all the bonds parameters, whereas Chen, Lesmond, and Wei (2007) carry out individual es-
timations. The authors recognize that their modeling approach prevents them from reliably
estimating their illiquidity measures for bonds with a censoring in excess of 85% in any given
year. These extreme bonds, however, are likely to carry precious information regarding
liquidity in the corporate bond market. Therefore, the additional benet of the proposed
methodology is to include bonds that trade very infrequently.
2.1 Evolution of Bond Returns and Liquidity Costs
I characterize the eect of liquidity on observed bond returns as R
it
= R

it
L
j
it
, j = {s, b}.
The latent true bond return R

it
, and the sell-side and buy-side liquidity costs L
j
it
, indexed
9
To be precise, Chen, Lesmond, and Wei (2007) estimate their models once a year for every bond in order
to preserve some time variation. and with observable bond characteristics.
10
In a recent paper, Omori and Miyawaki (2009) independently derive a tobit model with covariate depen-
dent thresholds and homoscedastic errors. However, their thresholds are linear functions of the covariates,
which complicates and slows down their sampling scheme in order to attain non-negative thresholds, and
depend on individuals only, but not on time.
7
by s and b respectively, are given by
R

it
=

i
x
it
+
it
,
it
N(0,
2
it
) (2.1)
L
s
it
=
s
i
( z
i
) exp{

z
it
},
s
i
< 0 (2.2)
L
b
it
=
b
i
( z
i
) exp{

z
it
},
b
i
> 0, (2.3)
where x
it
is a vector containing both systematic and idiosyncratic risk factors, z
i
is a vector
of time-invariant bond characteristics, and z
it
is a vector of time varying variables.
11
The
choice of the exponential in Equations (2.2) and (2.3) guaranties positivity of liquidity costs.
Returns are observed only when they are large enough (in absolute value) to justify
transaction costs. The observation rule of bond returns that I propose is a generalization of
the friction model originally proposed by Rosett (1959)
R
it
=
_

_
R

it
L
s
it
, R

it
< L
s
it
0, L
s
it
R

it
L
b
it
R

it
L
b
it
, R

it
> L
b
it
(2.4)
Round trip liquidity costs are obtained as
Cost
it
L
b
it
L
s
it
= [
b
i
( z
i
)
s
i
( z
i
)] exp{

z
it
}, (2.5)
which reduce to the LOT measure when z
i
= 1 and z
it
= .
11
See Section 4 for the exact specication of the proposed models.)
8
2.2 Observed and Augmented Likelihood
Given the parameters, the latent variables, and the friction model, the likelihood of every
observation is given by
p(R
it
|L
s
it
, L
b
it
,
i
,
2
it
, x
it
) =
_
1

it

_
R
it
+ L
s
it

i
x
it

it
__
1
{R
it
<0}

_
1

it

_
R
it
+ L
b
it

i
x
it

it
__
1
{R
it
>0}

_
L
b
it

i
x
it

it
_

_
L
s
it

i
x
it

it
__
1
{R
it
=0}
(2.6)
For purpose of estimation of the parameters entering Equation 2.1, it is better to work with
the augmented likelihood function (see e.g. Chib (1992))
p(R

it
|R
it
, L
s
it
, L
b
it
,
i
,
2
, x
it
) =
1

it

_
R

it

i
x
it

it
_
, (2.7)
where the rule for obtaining the latent variable R

it
is given by
p(R

it
|R
it
, L
s
it
, L
b
it
,
i
,
2
it
, x
it
) =
_

_
R
it
+ L
s
it
, R
it
< 0
TN
(L
s
it
,L
b
it
)
(

i
x
it
,
2
it
), R
it
= 0
R
it
+ L
b
it
, R
it
> 0
(2.8)
2.3 Prior Distributions and Hierarchical Structure
In order to reduce the variance of the estimates and preserve enough heterogeneity across
bonds, I propose a hierarchical bayesian panel regression model with random coecients.
12
12
See Tsionas (2002) for a similar approach in the context of stochastic frontier models, and Greene (2005)
for a frequentist treatment of heterogeneity in panel data estimators of the stochastic frontier model.
9
Formally, factor loadings and bond-specic average liquidity are distributed as

i
|

, N(

, ) (2.9)

s
i
|
s
, z
i
,
2
s
LogN(

s
z
i
,
2
s
) (2.10)

b
i
|
b
, z
i
,
2
b
LogN(

b
z
i
,
2
b
), (2.11)
where z
i
is a vector of time-invariant bond characteristics.
I simplify the variance structure of the error term in equation (2.1) as in Geweke (1993)
by using the decomposition
2
it
=
2
v
it
where

2
IG(sh, sc) (2.12)
r/v
it

2
(r). (2.13)
The degrees-of-freedom parameter r captures the extent of heteroscedasticity in the data.
Low values of r reect the prior beliefs that the data might contain several large outliers, while
large values of r are consistent with homoscedastic error terms. The model in equation (2.1)
may be represented (for every bond i) in matrix notation as R

i
= X
i

i
+
i
,
i
N (0,
2
V
i
),
where V
i
= diag(v
i1
, v
i2
. . . , v
iT
i
).
To complete the model, a few more prior distributions need to be specied. I impose at
priors for the parameters

,
s
,
b
, and , and diuse Inverse Wishart and Inverse Gamma
priors for the remaining parameters:
IW(
0
, N
0
) (2.14)

2
s
,
2
b
IG(sh, sc). (2.15)
10
2.4 Posterior Distributions
Bayesian estimation of the model parameters and latent variables requires the combination of
the likelihood of the model, and the use of prior information on the parameters. To simplify
notation, collect the parameters of the data generating process into
R
, and those of the
liquidity processes into
l
, and dene [
R
,
l
] and the prior over these parameters as
p(). We obtain the posterior distribution of the parameters and the latent variables, given
the data, as
p(, L
s
, L
b
|R, X, Z,

Z) p(R|L
s
, L
b
, X,
R
) p(L
s
, L
b
|Z,

Z,
l
) p(). (2.16)
For the estimation of
i
and
it
, it is convenient to work with the augmented likelihood:
p(, L
s
, L
b
, R

|R, X, Z,

Z) p(R

|L
s
, L
b
, R, X,
R
) p(L
s
, L
b
|Z,

Z,
l
) p(). (2.17)
Sampling directly from the joint posterior distribution of the parameters is not feasible.
However, the parameters can be estimated using a Markov Chain Monte Carlo (MCMC)
algorithm (see Appendix D), which is an iterative scheme to draw from the conditional
distributions of blocks of parameters of the vector . Conditional posterior distributions of
these blocks of parameters are derived in Appendix A.
3 Data
The data in this study come from ve sources. The xed investment securities data base
(FISD) provides bond characteristics; the trades reporting and compliance engine (TRACE)
contains the actual bond transaction data; CRSP contains stock price data; COMPUSTAT
contains balance sheet data; the Dow Jones trades and quotes (TAQ) database is used to
11
construct realized volatility, and its diusive and jump components. In Appendix B, I provide
details on these databases, and on the lters used to determine the nal sample.
3.1 Corporate Bond Transaction Data (TRACE)
Under the pressure from several government bodies and buy-side traders, on July 1, 2002,
the National Association of Securities Dealers (NASD) started a three-phase dissemination
process of corporate bond transactions through its trades reporting and compliance engine
(TRACE).
13
This process progressively increased the pool of bonds subject to dissemination
resulting, after 2004, in approximately 95% coverage of US corporate bonds. The only bond
transactions not reported to TRACE are those that take place in exchanges, e.g. NYSEs
automated bond system (ABS). Although the role of TRACE is to increase transparency
in the corporate bond market (see Bessembinder, Maxwell, and Venkataraman (2006) and
Edwards, Harris, and Piwowar (2007)), not all information is released after each transaction.
For instance, until recently the side of the transaction was unknown, and the size of the trade
is top-coded to one and ve million dollars for junk and investment-grade bonds respectively.
I use bond transaction data from January 2003 to December 2008. Bond characteristics
are obtained from the xed investment securities database (FISD) compiled by Mergent Inc.
I only include corporate bonds (medium term notes and debentures) with no optionality and
no credit enhancement which leads to a nal sample with senior unsecured bonds without
call, put, and conversion options. Because utilities and nancial rms are heavily regulated,
and their leverage might not be representative of the true credit situation of the rm, I only
include industrial rms in my nal sample. Implementing these lters, I obtain a starting
sample of 3099 corporate bonds which I then merge with TRACE to obtain transaction data.
The merge with TRACE results in a sample of 1601 corporate bonds.
I use information from the TRACE record le to lter out irregular and special trades, and
13
The body that oversees TRACE now is the Financial Industry Regulatory Authority (FINRA)
12
trades that include any dealer commission. To minimize the impact of unusual observations,
I keep price observations that pass the following screening:
14
|p med(p, k)| 5 MAD(p, k) + g, (3.1)
where g is a granularity parameter which I set equal to $1, and med(p, k), and MAD(p, k)
are respectively the centered rolling median, and median absolute deviations of the price
p using k observations (I set k = 20).
15
After implementing this screening, I keep bonds
that are traded on at least 20 distinct days. After imposing these lters, and merging the
resulting bond data with the CRSP, COMPUSTAT, and TAQ databases, I obtain a nal
sample of 984 bonds.
Table 1 reports descriptive statistics, grouped by year, on bond characteristics and trans-
actions. The nal sample includes 984 bonds issued by 181 entities (identied using the
parent id in FISD). Panel A of the table provides information on bond characteristics such
as issue size, coupon rate, and time to maturity at issuance. As can be seen, the time to
maturity at issuance has increased over time, while the average coupon rate has remained
quite stable ranging from 6.59% to 7.09%. Panel B reports descriptive statistics on trading
activity. There is a total of 1,916,412 trades spread over 6 years. Although this seems quite a
large number, there are in fact on average approximately 325 ( 1916412/984/6) trades per
bond per year, or 6.25 trades per week. Furthermore, there are substantial cross-sectional
dierences in trading activity depending on bond characteristics (see Table 2). This is the
rst indication of the scarce liquidity of the corporate bond market relative to the equity
market as the equity of a typical issuer in my sample often trades more than 10,000 times
in a single day. The bonds age at the time of trade averages 6.63 years, and is lower in
14
Brownlees and Gallo (2006) propose a similar algorithm, based on rolling trimmed statistics, to lter
TAQ data.
15
I also try to eliminate return reversals as in Bessembinder, Maxwell, and Venkataraman (2006) but this
procedure leaves too many observations that are clearly outliers.
13
the early TRACE years. Finally, the price and size percentiles of the distribution show that
approximately half of the trade prices are within 5% of par, and that a signicant proportion
of trade sizes (50%) is below $25,000 indicating an active presence of retail investors in the
corporate bond market.
Table 2 reports the number of bond transactions grouped by issue size (in one dimension)
and by two measures of bond seasoning (in the other dimension): Panel A considers a
classication by age; Panel B considers a classication by time to maturity. The number
in parenthesis represent the number of bonds in each category. This table shows that large
issues trade much more frequently. Bonds with an issue size smaller than 50 million (80
in total) trade 15568 times, while bonds with an issue size in excess of 250 million (353
in total) trade almost 1.5 million times during the same period. There is also substantial
variation in trading volume depending on age and time maturity, with large issues trading
less frequently as they age, and smaller issues doing just the opposite. Finally, trading
activity declines rapidly when bonds approach maturity.
3.2 Bond Returns and Credit Spreads
Bond returns are dened as
R
t
=
P
t
+ AI
t
+ C
t
P
t1
+ AI
t1
,
where P
t
is the clean price of the bond, AI
t
is the accrued interest over one period, and C
t
is
the coupon payment whenever it is paid (in which case AI
t
= 0). This denition presupposes
the existence of consecutive bond price observations. However, many bonds can go without
trading for weeks, or even months. Consistently with my model, I set R
t
= 0 if no trading
occurs. Care must be taken, however, on the rst day of trading after a period of stale prices,
as two consecutive genuine price observations are not available. To compute this return, I
use the last available stale price. I also conduct my analysis using a linearly interpolated
14
price
16
as the price that goes in the denominator, and the results are virtually identical.
Table 3 reports the rst four moments of the distribution of bond returns across credit
ratings and time to maturity. The last two rows in each panel report the percentage of
days in which bonds in a given category trade, and the total number of days in which these
bonds could have traded. Two things are worth noting in this table. First, the observed
bond return distribution is highly non-normal as can be seen from the the excess kurtosis
(fat tails). Second, there is a negative relation between ratings and trading for short- and
medium-term bonds, which disappears for long-maturity bonds. This lack of monotonicity
for long-term bonds is most likely due, however, to the presence of the heavily traded General
Motors and Ford bonds in the (long term) BB/B/CCC categories.
I compute credit yield spreads as the dierence between the daily yield on the corporate
bond (obtained by averaging the available yields on a given day) and the yield on the treasury
benchmark with the same time to maturity. The constant maturity benchmark yields are
from Datastream and are for the following yearly maturities: 1/12, 1/4, 1/2, 1, 2, 3, 5,
7, 10, 20, 30. I use linear interpolation to get the yield of intermediate maturities. Table
4 presents average credit spreads categorized by rating in one dimension and by time to
maturity (Panel A) or by year (Panel B) in the other dimension. With the exception of the
medium-term CCC-D category, which contains few observations, it can be seen that credit
spreads are increasing in time to maturity and in credit risk. The break down by year (Panel
B) reveals the eect of the credit crisis on credit spreads taking place in 2007 and 2008.
3.3 High-Frequency Equity Data (TAQ)
Given the documented importance of equity volatility, I use high-frequency equity data from
the NYSE trades and quotes (TAQ) database to compute equity realized volatility and to
16
For example, suppose there is a trade at t = 0 for $100, and no trade at t = 1, but there is a trade at t
= 2 for $102. The return for t = 1 is 0 and the return for t = 2 is 1%. In case of stale prices the return at
t=2 would be equal to 2%.
15
disentangle its diusive and jump components (see Figure 1 for an example). These two
components, as well as individual equity returns, are used as explanatory variables of bond
returns, and yield spreads. Before processing the data, I impose the lter presented in (3.1)
with k = 50 and g = 0.05. The choice of these parameters reects the fact that stock
tit-by-tic data are much more numerous and closer in time than bond transactions.
To screen out jumps, I use a nonparametric approach developed by Barndor-Nielsen and
Shephard (2004) which relies on the concepts of realized variance and bipower variation.
17
In
Appendix C, I explain briey the methodology to recover jumps from high frequency data,
and provide references for its exact implementation.
As an example, in Figure 1, I present the realized volatility (top graph) of Ford Motor
Company which is one of the most important players in the corporate bond market. The
middle and bottom graphs represent the diusive and jump component of volatility which
sum to realized volatility. As can be seen, volatility has increased substantially since Jan
2007, a pattern shared with the equity return volatility of most rms in the sample.
4 Estimation by Markov Chain Monte Carlo (MCMC)
In this section, I estimate the parameters of the bond return generating process, and the two
liquidity thresholds. I implement a Gibbs sampler whenever the posterior distribution of a
given block is a standard one, and a Metropolis-Hastings algorithm otherwise. In Appendix
D, I provide a pseudo-code which describes the estimation algorithm in detail.
17
See Huang and Tauchen (2005), Barndor-Nielsen and Shephard (2006) and Huang (2007) for an appli-
cation of this approach.
16
4.1 Friction Model Specications
I consider 3 dierent specications for the bond return generating process in equation (2.1):
for the LOT measure I use the changes in the long-term default-free rate (systematic bond
factor), and market equity returns (systematic equity factor) as in Chen, Lesmond, and Wei
(2007); in the second specication, in addition to the bond factor, I use rm equity returns,
and realized equity return volatility; in the last specication I substitute realized volatility
with its jump and diusive components. Following Chen, Lesmond, and Wei (2007), I
interact all the factors with the duration of the bond.
The liquidity covariates in the threshold component of the model, i.e. equations (2.2)
and (2.3), are: issue size (in log), coupon rate, time to maturity at issuance (in log), age (6
year interval dummies), calendar time (6 yearly dummies), and the dierence between the
30-day eurodollar rate and the 30-day treasure rate (TED spread). I use the log of issue size
and time to maturity because the distribution of the level of these variables is very skewed
18
.
4.2 LOT Measure with TRACE Data
Table 5 reports average estimates of the friction model proposed by Chen, Lesmond, and Wei
(2007) grouped by median time to maturity and median rating, where the median is taken
over the estimation period. Although I have estimated this measure for every bond, to be
consistent with Chen, Lesmond, and Wei (2007), I report results only for bonds that trade
on at least 15% of trading days. The results reported in the table are comparable to those
reported in Table 2 (page 129) of Chen, Lesmond, and Wei (2007) and are characterized by
a mostly negative relation between the LOT measure and credit quality. With regard to the
factor loadings, it can be seen that the loadings on the bond factors are mostly negative,
but not increasing with credit risk as one would expect from theory. The idea is that highly
18
Histograms of these distributions are available upon request
17
rated bonds behave more like treasuries and their value varies with interest rates rather than
with the equity market factor. With regard to the loading on the systematic equity factor,
the table shows that this loading is often positive, but there are some exceptions especially
for short-term bonds.
Figure 2 reports the distribution of the parameter estimates of the LOT model: the rst
row reports the distribution of the factor loadings; the second row reports the distribution of
the sell- and buy-side transaction costs; the last row reports the distributions of the estimated
round-trip liquidity costs. The most important feature of these graphs is the dispersion in
the parameter estimates. While the bond factor loadings are negative on average, it can
be seen that there are estimates as high as almost 10. The same observation can be made
for the equity factor loading: its slightly positive on average, but it can get quite negative.
Finally the LOT measure can be as high as 45%, making this measure hard to attribute only
to transaction costs. Moreover, when I estimate the LOT measure on bonds that trade very
infrequently, this measure can be as high as 80%. The top panel of Figure 4 shows a scatter
plot of the LOT measure against the percentage of zero trading days. As can be seen, for
bonds that trade less than 15% of the time (when the x axis approaches 1) estimation of the
LOT measure becomes very unreliable.
4.3 Idiosyncratic Factors and Time-Varying Liquidity
Table 6 presents average estimation results for the parameters in the return component of
the model (Equation (2.1)). The results are categorized by (median) rating and time to
maturity. The dierence between the two models in the table is that in the second one
realized volatility is replaced by its diusive and jump components. At daily frequency, the
results are very similar and, therefore, the following comments are good for both models.
Bond factor loading are mostly negative, and are increasing with credit rating. The average
18
rm-specic equity factor loading is always positive, which means that good news for equity
holders are typically good news for bond holders given that debt and equity are both positive
claims on the assets of the rm. The average volatility factor loading is always negative which
means, assuming that leverage is not too variable, that an increase in business risk typically
causes a deterioration in the value of debt. Contrary to what I nd for the LOT measure,
on average the time-invariance component of round-trip liquidity costs (given by the rst
part of the expression in Equation (2.5)) is on average well below 5% and does not display
a systematic relation with credit ratings (hence credit spreads).
The hierarchical panel approach, and the resulting shrinkage of individual parameters
toward a common parameter, provides a more robust estimation which avoids the occurrence
of very extreme estimates. In Figure 3, I provide graphical evidence of the eect of shrinkage
in the estimation of the factor loadings. As we would expect from theory, systematic bond
factor loadings are mostly negative. Similarly, the equity and volatility factor loading are
mostly positive and negative respectively. Overall, joint estimation of the parameters avoids
the occurrence of very extreme estimates. The bottom plot of Figure 4 shows graphically
the stability of the proposed liquidity measure, relatively to the LOT measure, for bonds
that trade very infrequently.
Table 7 reports estimates of the sensitivity of liquidity costs to several bond character-
istics and to the Eurodollar-Treasury (TED) spread (see Equations (2.2) and (2.3)). The
dierence between the two models in the table is in the return component only: in the second
model realized volatility is replaced by its diusive and jump components. The rst two sets
of estimates (Panel A and B) refer to time-invariant regressors and account for asymmetric
responses depending on the sign of observed returns. As can be seen, on average, liquidity
costs are quite symmetric. Panel C refers to those regressors that change over time.
19
For
19
For numerical reasons I do not allow for asymmetric responses as this would slow the estimation down
as the vector is most expensive parameter to estimate in terms of time/iterations.
19
each model, the rst two columns provide the mean and standard deviation of the poste-
rior distribution; the next two columns report the 1
st
and 99
th
percentiles of the posterior
distribution and can be seen as a bayesian condence interval for the estimated coecients.
Except for the rst three age brackets, all the variables are statistically signicant in the
sense that the posterior means are at least two standard deviations away from zero.
Age and issue size are strong determinants of trading activity and round-trip transaction
costs (see Hotchkiss and Jostova (2007)). In particular, a 1% increase in issue size is asso-
ciated with a 0.55% decrease in liquidity cost. The coecients on the age dummies reveal
that for young bonds age has not much of an eect on liquidity, but, after approximately 9
years, age starts having a bigger and bigger impact. The negative coecient on the log of
maturity means that the eect of ageing is more pronounced for bonds that are close to ma-
turity. The coupon rate is supposed to capture the eect of taxes (Elton, Gruber, Agrawal,
and Mann (2001)) and the coecient on this variable reveals that one point increase in the
coupon rate increases liquidity costs by approximately 0.13%. The TED spread, which is
meant to capture ight-to liquidity eects, has a positive eect on liquidity costs. Lastly, the
coecients on the year dummies reveal clearly the anatomy of the nancial crisis. Relative
to 2003, liquidity costs have been going up every year until 2007 (when they picked), and
have come down in 2008, but not to pre-crisis levels.
4.4 A Brief Discussion on the Role of Jump Variation
Model 2 estimates in Table 6 and 7 reveal that, at daily frequencies, disentangling the dif-
fusive and jump components of realized volatility does not change the estimated coecients
very much. However, although the changes (going from Model1 to Model2) in the LOT
estimates in Table 6 are not very big, it is evident that by controlling for more risk factors
the estimated liquidity costs are smaller.
20
The inability of jump variation to reveal its impact on the estimates is also likely due
to the fact that jumps are rare events and many days can go by without observing any
jumps. As a result, the jump variation variable has many more zeros elements than non-zero
ones and this might make it dicult to appreciate its impact. This zero-element problem
is exacerbated at daily frequency and could be substantially mitigated using weekly data. I
leave the exploration of other lower frequencies for future research.
Finally, it is important to observe that although disentangling jumps from diusive move-
ments does not add explanatory power at a daily frequency, this does not mean that jumps
are not important. It just means that, for the purposes of this study, the impact of jumps
is best appreciated using realized volatility, which is the sum of both jump and diusive
volatility.
5 Volatility, Liquidity, and Yield Spreads
In this section, I examine the determinants of credit spreads with the objective of establishing
whether volatility (information) or liquidity (friction) plays a dominant role. The general
specication of the regressions is given by
Y ield Spread
it
= +

1
Illiquidity
it
+

2
V olatiltiy
it
+

3
Rating Dummies
it
+

4
Accounting V ariables
it
+

5
Macro V ariables
t
+

6
Other V ariables
it
+
it
,
and is similar to those estimated by Campbell and Taksler (2003) and Chen, Lesmond, and
Wei (2007).
21
5.1 Yield Spread Determinants: Univariate Analysis
A preliminary graphical analysis reveals that realized volatility plays a very important role
in explaining credit spreads. Figure 5 shows that equity realized volatility (bottom graphs)
is at least as important as credit ratings (upper graphs) in explaining credit spreads. In the
plots I use logs to deal with the heteroscedastic nature of bond yields, the variance of which
increases with credit risk. Another way to deal with heteroscedasticity, as it is often done
in a regression context (e.g. Campbell and Taksler (2003)), is to use a trimmed sample in
which the top and bottom percentiles of yield spreads are eliminated.
Table 8 reports regression estimates of both level and log of yield spreads on several
liquidity measures, realized volatility, and credit ratings. Consistently with the graphical
evidence, the table shows that realized volatility has at least as much explanatory power
as credit ratings. Specications that include both variables show that rating and realized
volatility alone can explain as much as 60% of the variation in corporate yield spreads.
With regard to the explanatory power of the three trading-based illiquidity measures
(model 1 through 3) considered in this study, it can be seen that the LOT measure is
positively associated with credit spreads, which is to be expected given the results of Table
5, and can explain as much as 14% of the cross sectional variation. In contrast to the LOT
measure, the other two measures of illiquidity are (unconditionally) uncorrelated with yield
spreads. Two facts are worth noting about this result. First, in unreported results I nd that
when I regress yield spreads on the LOT measure using the full sample (including infrequently
traded bonds), the R
2
falls to zero. Secondly, the explanatory power of the LOT measure in
a univariate context seems to stem from the positive correlation (approximately 12%) that
this measure has with realized volatility.
20
The other two measures are uncorrelated with
realized volatility.
20
This correlation is to be considered as a lower bound since, unlike realized volatility, the LOT measure
varies only over bonds and not over time.
22
5.2 Yield Spread Determinants: Multivariate Analysis
In Table 9, I estimate several regression models similar to those estimated by Campbell and
Taksler (2003) and Chen, Lesmond, and Wei (2007). The main message of this table is that
liquidity variables contribute minimally to the determination of credit spreads, while credit
risk variables such as volatility and leverage have signicant economic impact.
21
In the rst
three models of the table I include one liquidity measure at the time, while model 4 excludes
them. Although the liquidity variables are characterized by a positive and signicant coe-
cient, their exclusion has practically no impact on the model t (R
2
) and on the magnitude
and sign of the remaining coecients.
To appreciate the economic impact of credit risk variables, note that a one-standard
deviation change (approximately 0.18) in realized volatility is associated with a variation
in credit spreads of 82 basis points ( 4.58% 0.18) and a one-standard deviation change
(approximately 0.12) in market leverage is associated with a positive variation in credit
spreads of approximately 43 basis points ( 3.61%0.12).
The ability of credit risk variables to explain credit spreads so well relatively to other
studies is likely due to two reasons. First, realized volatility carries more information than
equity volatility estimated with historical data up to 180 days before the date of interest.
The realized volatility measure that I propose are updated daily, and therefore incorporate
information as it happens and are not smoothed like more conventional historical measures.
Secondly, in the sample period of my study, which includes the recent credit crisis, credit
risk has manifested itself pervasively conrming, ex-post, the expectations that investors
formed, ex-ante, when requiring such high premia to hold corporate bonds. The subsection
on robustness checks further develops this last point.
Regressions in which I substitute realized volatility with its diusive and jump compo-
21
Using dierent data, and a dierent methodology, Kalimipalli and Nayak (2009) reach a similar conclu-
sion.
23
nents are similar to those reported in Table 9. The coecients on the diusive component
are approximately the same as those on realized volatility, while the coecients on the
jump component are half the size. Given the similarity of the results, I do not report these
regressions, but make them available on request.
5.3 Robustness Checks
In the remainder of the paper, I conduct some further analysis to assess the robustness of
the results to the use of more general standard errors and to several partitions of the sample.
5.3.1 Clustered Standard Errors
As can be seen from Tables 8 and 9, the t-statistics associated to the estimated coecients
are rather large, which is likely due to the assumption of spherical disturbances underlying
OLS standard errors. It is reasonable to assume that observations relative to bonds issued
by the same issuer are not mutually independent. To account for the dependence induced by
issuer-specic eects, I rerun the multivariate regressions of Table 9 using standard errors
clustered by issuer.
22
Table 10 reports the multivariate regressions of Tables 9 with clustered-adjusted stan-
dard errors. As can be seen, while the t-statistics have shrunk substantially making some
variables no longer signicant, they are still high enough to make the variables of interest,
e.g. realized volatility, strongly signicant in a statistical sense. Finally, the large reduction
in the t-statistics signals the relevance of individual eects and the inappropriateness of the
assumption of independent observations implied by the OLS procedure for deriving standard
errors.
22
See Petersen (2009) and Gow, Ormazabal, and Taylor (2009) for applications of these standard errors in
nance and accounting. I obtained the Matlab code for running regressions with clustered standard errors
at http://www.stanford.edu/
~
djtaylor/research/.
24
5.3.2 Investment Grade Vs Junk Bonds
Table 11 reports several yield spread regressions for two sub-samples: one sub-sample in-
cludes only investment grade bonds (models 1 and 2); the other sub-sample includes junk
bonds (models 3 and 4). Table 11 diers from Table 9 in two ways. First, the highest two
interest coverage dummies have been merged because there were no junk bonds with high
enough interest coverage. Secondly, the regressions do not include rating dummies as the
sample is already partitioned using rating information. Notice, that, in the interest of space,
I have only included the two most important liquidity measures.
The regressions in Table 11 reveal that both volatility and (to some extent) illiquidity play
a bigger role in the sub-sample of junk bonds. While volatility is still strongly economically
and statistically signicant, the proposed illiquidity measure loses its signicance in the junk
bond sample and the size of the coecient remains practically unchanged. The standard LDV
measure of Chen, Lesmond, and Wei (2007) is characterized by a much higher coecient in
the junk bond sample, which is consistent with the nding of their paper. This phenomenon is
further evidence that this illiquidity measure is more correlated to credit spreads in situations
in which credit risk is more relevant.
5.3.3 Pre-Crisis Vs Crisis Yield Spreads
Table 12 reports several yield spread regressions for two sub-samples: one sub-sample in-
cludes the period January 2003-December 2006 (models 1 and 2); the other sub-sample
includes the period January 2007-December 2008 (models 3 and 4). The pattern of the
change in coecients is similar to the case in which the partition is done according to credit
rating. For instance, the coecient on realized volatility is much higher now. The stan-
dard deviation of volatility is also higher in the crisis sub-sample which makes the economic
impact of volatility even higher.
25
The most striking dierence between the two sets of regressions is in their explained
variation. Approximately 15% in the pre-crisis sample, the R
2
jumps to 57% in the crisis
sample. This nding is consistent with the manifestation of credit risk particularly in the
last two years of data.
6 Conclusion
In order to remedy the inability of structural credit risk models to adequately t corporate
bond data, the literature has focused on illiquidity as a concurring determinant of corporate
yield spreads. Several recent papers have concluded that liquidity is an important factor in
the determination of credit spreads, especially for junk bonds. In this paper, I argue that
certain illiquidity measures appear to do especially well in explaining yield spreads because
they are in fact picking up credit risk.
Using transaction data from TRACE, and high-frequency volatility measures from TAQ,
I nd that a substantial portion of yield spreads is explained by equity volatility, indicating
that investors seek reward for bearing credit risk. In particular, I nd that equity realized
volatility explains as much yield spread variation as that explained by credit ratings. The
explanatory power of credit risk variables, and their ability to explain away well known
illiquidity measures, suggests that the liquidity component of yield spreads is less important
than previously thought.
26
A Conditional Posterior Distributions
A.1 Conditional Distribution of
i
and
2
it
To the derive the conditional posterior distribution of
i
and
2
it
, it is more convenient to
work with the augmented likelihood in (2.7). To see this, notice that, once we augment
that data with the auxiliary variable R

it
, the likelihood function is the standard likelihood
function of a linear regression model, and the standard conditional distributions apply.
Using vector notation on the time observations, and dening V
i
= diag(v
i1
, v
i2
. . . , v
iT
i
),
we can multiply the likelihood in (2.17) and the prior distribution in (2.9) to obtain
p(
i
|

, ,
2
, V
i
, R

i
, X
i
) N(

B
i
,

V
i
), i = 1, . . . , N (A.1)
where

B
i
=

V
i

_
X

i
V
1
i
R

i
/
2
+
1

_
and

V
i
=
_
X

i
V
1
i
X
i
/
2
+
1
_
1
.
The posterior distribution for
2
is given by
p(
2
|{}
N
i=1
, , R

i
, X
i
) IG(
N

i=1
T
i
/2 + sh,
N

i=1
SSR
i
/2 + sc), (A.2)
where SSR
i
(R

i
X
i

i
)

V
1
i
(R

i
X
i

i
) and T
i
is equal to the number of censored and
uncensored observations available for bond i.
Finally, the distribution of the time-varying component of the variance has been shown
by Geweke (1993) to be implicitly given by
e
2
it
/
2
+ r
v
it
|
i
,
2

2
(r + 1), (A.3)
where e
2
it
is the squared residual of observation it.
27
A.2 Conditional Distribution of
s
i
and
b
i
To obtain the posterior distribution for this parameter, I need to combine the observed
likelihood in (2.6) with the expressions in (2.2), and (2.3). Dening l = log(L), The posterior
distribution of
s
i
is given by
p(
s
i
|
i
,
2
it
, R
it
, x
it
, L
s
it
, L
b
it
) p(R
it
|L
s
it
, L
b
it
,
i
, 2, x
it
) p(l
s
it
|
si
,
2
s
, z
it
)
exp
_

1
2
_
R
it
+ L
s
it

i
x
it

it
_
2
_
1
{R
it
<0}

_
L
b
it

i
x
it

it
_

_
L
s
it

i
x
it

it
__
1
{R
it
=0}

exp
_

1
2
_

s
i

s
z
i

s
_
2
_
. (A.4)
The posterior distribution of the buy-side liquidity costs is given by
p(
b
i
|
i
,
2
it
, R
it
, x
it
, L
s
it
, L
b
it
) exp
_

1
2
_
R
it
+ L
b
it

i
x
it

it
_
2
_
1
{R
it
>0}

_
L
b
it

i
x
it

it
_

_
L
s
it

i
x
it

it
__
1
{R
it
=0}

exp
_

1
2
_

b
i

b
z
i

b
_
2
_
. (A.5)
The expressions in (A.4) and (A.5) do not resemble the kernels of any well known distribution.
Therefore, I implement a Metropolis-Hastings algorithm to sample from these unknown
target distributions.
28
A.3 Conditional Distribution of
s
and
b
Given the at prior, the distribution of
s
is given by
p(
s
|{
s
i
}
N
i=1
,
2
s
, z
i
) N( ,

V ), (A.6)
where =

V ( z

s
/
2
s
) and

V
i
=
2
s
( z

z)
1
. Note that the posterior parameters of the dis-
tribution are just the OLS slope and its covariance matrix. A similar posterior distributions
can be obtained for
b
.
A.4 Conditional Distribution of

and
Combining the distributions in which it appears,

can be shown to have the following
posterior conditional distribution:
p(

|{}
N
i=1
, )
N

i=1
N(
i
, )
N
_
N

i=1

i
/N, /N
_
. (A.7)
Using the the linearity and cyclic property of the trace operator, the posterior conditional
distribution for is given by
p(

|{}
N
i=1
, ) IW(
0
, N
0
)
N

i=1
N(
i
, )
||

N+N
0
+K+1
2
exp{tr(
1
(
0
+
1
))}
IW(
0
+
1
, N + N
0
), (A.8)
where
1

N
i=1
(
i

)(
i

.
29
A.5 Conditional Distribution of
To obtain the posterior distribution for this parameter, I need to combine the observed
likelihood in (2.6) with the expressions in (2.2), and (2.3). The posterior distribution of is
given by
p(
s
i
|
i
,
2
it
, R
it
, x
it
, L
s
it
, L
b
it
) p(R
it
|L
s
it
, L
b
it
,
i
, 2, x
it
) p(l
s
it
|
si
,
2
s
, z
it
)
exp
_

1
2
_
R
it
+ L
s
it

i
x
it

it
_
2
_
1
{R
it
<0}

_
L
b
it

i
x
it

it
_

_
L
s
it

i
x
it

it
__
1
{R
it
=0}

exp
_

1
2
_
R
it
+ L
b
it

i
x
it

it
_
2
_
1
{R
it
>0}
. (A.9)
The expressions in (A.9) does not resemble the kernel of any well known distribution. There-
fore, I implement a Metropolis-Hastings algorithm to sample from this unknown target dis-
tribution.
A.6 Conditional Distribution of
2
s
and
2
b
The derivation of the posterior conditional distribution for
2
j
, j = {s, b} is given by
p(
2
j
|{
j
i
, z
i
}
N
i=1
) IG(N/2 + sh, SSR/2 + sc) , j = {s, b} (A.10)
where SSR
i
(
j
z
j
)

(
j
z
j
) and N is equal to the number of bonds.
B Databases and Merging
To conduct my analysis, I use 5 databases. Below, I briey describe the databases and the
lters used for the sample selection.
30
1. FISD to obtain bond characteristics (e.g. rating, issue size) and identify the sample
of bonds to include in the study; the unique identier for each issue in this database is
the bond 9-letter cusip; I impose several lters to dene the initial sample (before the
merge with TRACE) with the following self-explanatory SAS commands (in a data
step):
where security_level = SEN and
convertible = N and
putable = N and
redeemable = N and
exchangeable = N and
bond_type in (CDEB,CMTN) and
coupon_type = F and
foreign_currency = N ;
The above commands exclude bonds that are convertible, putable, callable, and ex-
changeable and keeps bonds that are either corporate debentures or medium term
notes, and xed-rate bonds denominated in US dollars;
2. TRACE to obtain transaction prices; note that most of the bonds in TRACE are
covered by FISD; the unique identier for each issue in this database is the bond 9-
letter cusip; I use the following SAS commands (in an SQL step) to impose lters on
TRACE data:
where [...]
&StartDate <= a.trd_exctn_dt <= &EndDate and /*time filter*/
a.sale_cndtn_cd = @ and /*regular sale condition*/
31
a.spcl_trd_fl ne Y and/*get rid of special sales and prices*/
a.wis_fl = N and /*regular, no when-issued basis*/
a.cmsn_trd = N and /*price excludes commission*/
a.spcl_trd_fl = and /*non-special price trade*/
a.asof_cd = ; /*regular trade, e.g. no reversal*/
In addition to imposing the above lters, I also make sure to exclude or correct misre-
ported transactions as documented by TRACE and to eliminate repeated inter-dealer
trades;
3. CRSP to obtain stock returns of the company currently backing a given bond; the
unique identier for each rm and securitiy in this database are the PERMCO and
PERMNO numbers respectively;
4. COMPUSTAT to obtain balance sheet information on the company backing a given
bond; rms are identied by their GVKEY number;
5. TAQ to obtain 5-minute returns to construct the realized variance measures used in
the specication of the bond return generating process; securities are identied by their
TICKER symbol (which varies over time and is not a unique identier).
The link between these databases is straightforward in some cases and quite complicated in
others. FISD and TRACE are easily linked through the 9-letter cusip. Once a preliminary
sample of bonds is formed, to see whether a rm with public equity is backing them, I match
the six-letter cusip (which identies the rm at issuance in the FISD database) with the
historical cusip (NCUSIP) in the CRSP stocknames table. During this merge I obtain the
historical tickers, and PERMCO and PERMNO numbers associated with rms CUSIPs,
which I then use to get data from COMPUSTAT and TAQ.
32
C Extracting Jumps from Realized Variance
To screen out jumps, I use a nonparametric approach developed by Barndor-Nielsen and
Shephard (2004) which relies on the concepts of realized variance and bipower variation.
23
The idea is that, as we sample price data at very high frequency, the limiting behaviors of
the return realized variance and bipower variation capture dierent aspects of the return
process. More formally, given a log asset price p(t), we can dene the instantaneous return
of the associated jump-diusion process as
dp(t) = (t)dt + (t)dW(t) + k(t)dq(t), 0 t T, (C.1)
where (t) and (t) are the drift and the diusion of the process, W(t) is a standard Brownian
motion, q(t) is a counting process which controls the arrival of jumps, and k(t) is the size
of the jumps upon arrival. I refer to Andersen, Bollerslev, and Diebold (2007) for a precise
description of the parameters of the process and their properties. Given a sample of high-
frequency price data in a given day, one can create -period returns, where is a fraction
of the day, as r
t,
p(t) p(t ). Setting the time interval to unity, we get 1/ intervals
in a day, and we also have r
t+1
r
t+1,1
. It can be shown that the realized variance converges
uniformly in probability to the quadratic variation of the process:
RV
t+1
()
1/

j=1
r
2
t+j,

_
t+1
t

2
(s)ds +

t<st+1
k
2
(s), (C.2)
23
See Huang and Tauchen (2005), Barndor-Nielsen and Shephard (2006) and Huang (2007) for an appli-
cation of this approach.
33
for 0. The other object of interest, the bipower variation, converges to just the
diusive component of the quadratic variation of the process:
BV
t+1
()
1
1/

j=2
|r
t+j,
||r
t+(j1),
|
_
t+1
t

2
(s)ds, (C.3)
for 0, where
1

_
2/.
It can be shown (see Barndor-Nielsen and Shephard (2004) and Andersen, Bollerslev,
and Diebold (2007)) that the dierence between the quantities in expressions (C.2) and (C.3)
converges to

t<st+1
k
2
(s). In most applications (e.g. Andersen, Bollerslev, Diebold, and
Ebens (2001)), including mine, 5-minute returns are typically used to obtain daily measures
of realized variance and bipower variation, i.e. is small but not zero, so this dierence is
not even guarantied to be positive. To deal with this issue, Barndor-Nielsen and Shephard
(2004) propose a statistical procedure to determine whether price variation is due to jumps
or diusive movements based on the test statistics RJ
it

RV
it
BV
it
RV
it
, which, appropriately
scaled, converges to a standard normal distribution. I implement this methodology exactly
as in the appendix (p. 35) of Zhang, Zhou, and Zhu (2009).
D Estimation Algorithm
Given the conditional posterior densities derived in the previous section, I implement the
Gibs sampler, and Hasting-Metropolis algorithm it, as follows.
1. Initialize the chain by assigning {R

i
,
1
, . . . ,
N
,
1
, . . . ,
N
, , V
i
,

, ,
s
,
b
, ,
s
,
b
}
0
;
2. Move the Markov chain one step forward by drawing parameters from the posterior
densities derived in the previous sections. In particular, we obtain updated values (not
necessarily in this order), for j > 0, as follows:
34
R

i
j
|R
i
, L
s
i
j1
, L
b
i
j1
, i = 1, . . . , N: use equation (2.8);

j
i
|
j1
, V
j1
i
,

j1
,
j1
, i = 1, . . . , N: use equation (A.1);

j
|{
1
. . .
N
}
j
, {V
1
. . . V
N
}
j1
: use equation (A.2);
V
j
i
|
j
i
,
j
, i = 1, . . . , N: use equation (A.3);

j
|{
1
. . .
N
}
j
,
j1
: use equation (A.7);

j1
|

j
, {
1
. . .
N
}
j
: use equation (A.8);

j
s
|{L
s
1
. . . L
s
N
}
j1
: use equation (A.10); similarly for
b
;

j
s
|{L
s
1
. . . L
s
N
}
j1
, {L
b
1
. . . L
b
N
}
j1
: use equation (A.6); similarly for
j
b
;

s
i
,
b
i
,
j
: the posterior densities of interest are proportional to the expressions in
(A.4) , (A.5), and (A.9) respectively, and a Metropolis-Hastings (within-Gibbs-
sampler) algorithm is required to sample from this non-standard distributions.
The procedure for generating a generic sample from one of these distributions
works as follows:
given the current sample previously drawn,
c
, generate a new sample
p
from
the proposal distribution q(
p
|
c
); the proposal and target density should have
the same support;
evaluate the acceptance probability as
(
p
|
c
) = min
_
1,
p(
p
)q(
c
|
n
)
p(
c
)q(
p
|
c
)
_
accept the proposed value
p
with probability (
p
|
c
), i.e.
{}
j+1
=
_

p
, with prob (
p
|
c
)

c
, with prob 1 (
p
|
c
)
35
The proposal density for
s
and
b
is a truncated normal, i.e. q(
p
|
c
) TN(0, 2),
where
2
is a perturbation parameter; the proposal for is a normal distribution;
3. Repeat step 2 J times, where J is large enough to ensure convergence of the chain;
4. Discard the rst K
36
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41
Table 1: Summary Statistics of Corporate Bond Transactions
This table presents summary statistics, categorized by year, of bond characteristics (Panel A) and bond
transactions (Panel B). The bonds described in this table must have data on FISD, TRACE, CRSP, COM-
PUSTAT, and TAQ. Moreover, bonds that trade on less than 20 trading days are excluded from the sample.
Issues is the number of bonds. Issuers is the number of issuers at the parent company level according to
the FISD database. Issue Size is the average issue size. Coupon is the average xed coupon rate. TTM
at Issuance is the time to maturity at issuance. Trades is the total number of trades of the bonds in the
sample. Age is age measured in years, or as a percentage of the life span of the bond, at the time of trade.
Trade Price is the price, as a percentage of par, of the bond (several quantiles are provided). Trade Size is
the dollar size of the transaction (several quantiles are provided).
2003 2004 2005 2006 2007 2008 2003-2008
Panel A: Bond Characteristics
Issues 480 816 887 789 696 607 984
Issuers 104 161 176 164 151 136 181
Issue Size ( $1,000,000) 663.43 439.46 406.91 414.34 451.63 465.80 441.77
Coupon 6.59 6.73 6.87 6.90 6.98 7.09 6.83
TMM at Issuance 16.89 17.37 17.65 18.47 19.98 21.36 16.68
Panel B: Transactions Characteristics
Trades 257,157 290,672 427,881 359,588 265,618 315,496 1,916,412
Bond Age as of Trade
Years 4.70 5.30 6.70 7.43 7.89 7.36 6.63
Pct Life 0.39 0.40 0.48 0.54 0.53 0.52 0.48
Trade Price (pct of par )
Minimum 39.50 19.00 10.00 18.95 10.50 0.01 0.01
First Quartile 99.78 99.75 92.95 91.00 96.33 96.00 96.30
Median 105.15 103.75 100.30 99.39 99.90 100.27 100.64
Third Quartile 110.40 108.59 104.25 101.87 102.96 102.90 105.10
Maximum 158.91 151.07 159.85 148.66 144.45 151.47 159.85
Trade Size ( $1,000)
Minimum 1 1 1 1 1 1 1
First Quartile 10 10 10 10 10 10 10
Median 30 25 25 25 25 20 25
Third Quartile 175 100 100 95 90 50 100
Maximum 5000 5000 5000 5000 5000 5000 5000
42
Table 2: Trading Activity by Bond Characteristics
This table presents summary statistics of corporate bond transactions categorized by age and issue size
(Panel A), and time to maturity and issue size (Panel B). The bonds described in this table must have data
on FISD, TRACE, CRSP, COMPUSTAT, and TAQ. Age and Time to Maturity are measured in years at
the time of trade. Size is the dollar issue size of the bond. The numbers in the table represent the trade
occurrences with a given size-age or size-TTM combination. The number in parenthesis represent the number
of bonds falling in each category. Notice that for the number in parentheses the marginal distribution is not
obtained by summing summing numbers in the joint table as the a given bond might be in more than one
category during its life.
Issue Size ($1,000,000)
50 (50 100] (100 250] (250 500] > 500
PANEL A: by Age (in years)
3 705 3,200 22,793 116,676 269,446 412,820
( 1) ( 5) ( 39) ( 80) ( 55) ( 180)
(3 5] 1,404 3,048 17,280 73,834 230,130 325,696
( 3) ( 19) ( 83) ( 81) ( 58) ( 244)
(5 7] 2,351 7,830 50,974 80,643 190,461 332,259
( 18) ( 37) ( 150) ( 89) ( 48) ( 342)
(7 10] 6,854 22,231 139,183 203,068 122,685 494,021
( 52) ( 85) ( 246) ( 112) ( 46) ( 541)
> 10 5,254 23,702 130,511 139,360 52,789 351,616
( 56) ( 73) ( 237) ( 102) ( 30) ( 498)
16,568 60,011 360,741 613,581 865,511 1,916,412
( 80) ( 134) ( 417) ( 243) ( 110) ( 984)
PANEL B: by Time to Maturity (in years)
1 1,611 8,057 45,707 75,362 55,135 185,872
( 42) ( 74) ( 208) ( 131) ( 50) ( 180)
(1 3] 5,472 15,411 85,534 156,583 125,382 388,382
( 55) ( 75) ( 200) ( 131) ( 52) ( 244)
(3 5] 3,822 9,705 54,543 105,007 144,106 317,183
( 50) ( 50) ( 140) ( 97) ( 41) ( 342)
(5 10] 3,483 10,177 47,375 89,355 252,125 402,515
( 27) ( 38) ( 95) ( 71) ( 36) ( 541)
> 10 2,180 16,661 127,582 187,274 288,763 622,460
( 13) ( 43) ( 162) ( 74) ( 45) ( 498)
16,568 60,011 360,741 613,581 865,511 1,916,412
( 80) ( 134) ( 417) ( 243) ( 110) ( 984)
43
Table 3: Summary Statistics of Corporate Bond Returns
This table presents summary statistics of bond returns grouped by rating and maturity, with short-maturity
bonds in Panel A, medium-maturity bonds in Panel B, and long-maturity bonds in Panel C. The rst four
rows of each panel report the average across bonds of the rst four moments of returns. The mean is reported
in basis points. Pct Trading is the percentage of days in which the bonds in a given category traded, i.e.
days with trading over trading days. The last row reports the total number of days in which the bonds in
a given category could have traded. The statistics are calculated using data from trading days only, thus
ignoring zero returns originating from zero-trading days.
AAA AA A BBB BB B CCC-D
Panel A: Short Maturity (0-2 years)
Mean (bp) 0.673 0.274 -0.423 -0.351 -0.784 0.754 -0.865
St. Dev. 0.005 0.005 0.007 0.007 0.013 0.018 0.025
Skewness -0.110 -0.385 0.012 -0.502 0.055 0.172 -0.772
Kurtosis 8.604 9.112 21.945 20.835 15.733 172.947 113.249
Pct. Trading 0.809 0.633 0.441 0.349 0.292 0.396 0.371
Trading Days 2472 25935 93286 69803 13617 9077 4680
Panel B: Medium Maturity (3-10 years)
Mean (bp) 1.355 1.140 0.477 -1.312 -2.911 -2.648 -0.267
St. Dev. 0.012 0.010 0.013 0.018 0.022 0.035 0.053
Skewness 0.063 0.025 0.019 1.796 -3.009 5.870 -0.065
Kurtosis 6.496 11.313 14.673 174.692 71.886 288.178 22.081
Pct. Trading 0.792 0.624 0.449 0.366 0.382 0.356 0.436
Trading Days 9192 41482 142264 103432 17567 18053 12699
Panel C: Long Maturity (more than 10 years)
Mean (bp) 4.514 3.515 2.026 -1.102 -5.895 -1.669 1.482
St. Dev. 0.024 0.026 0.026 0.028 0.032 0.033 0.065
Skewness 0.100 -0.053 -0.038 -0.087 -0.125 -0.280 0.892
Kurtosis 5.600 8.008 7.198 16.828 9.866 23.624 16.866
Pct. Trading 0.431 0.245 0.259 0.290 0.498 0.394 0.464
Trading Days 7541 32968 138939 117910 17718 19006 20906
44
Table 4: Average Corporate Credit Spreads
This table presents average credit spreads categorized by S&P rating, and subsequently by time to maturity
(Panel A), and by year (Panel B). Credit spreads are dened as the dierence between daily yield spreads
(obtained by averaging the available yields on a given day) and the yields on the treasury benchmark with
the same time to maturity. The constant maturity benchmark yields are from Datastream and are for the
following yearly maturities: 1/12, 1/4, 1/2, 1, 2, 3, 5, 7, 10, 20, 30. I use linear interpolation to get the yield
of intermediate maturities. Transactions for which the spread is negative are not included in the sample.
AAA AA A BBB BB B CCC-D
Panel A: Breakdown by Time to Maturity (in years)
Short (0-2) 42 72 107 126 331 443 900
Medium (3-10) 63 61 90 169 331 497 1292
Long (> 10) 62 108 142 225 444 590 904
Panel B: Breakdown by Year
2003-2008 60 73 109 179 391 531 1002
2003 36 62 92 202 200 553 819
2004 60 53 75 137 205 231 561
2005 40 47 76 159 385 286 1184
2006 46 57 84 123 411 413 744
2007 65 81 109 148 270 399 527
2008 152 163 270 382 591 1247 1679
45
Table 5: LOT Measure with TRACE Data
This table presents estimation results for the parameters of the bond return generating process underlying
the modied LOT measure as described in the paper by Chen, Lesmond, and Wei (2007). One dierence with
the original implementation of this measure is that I use all the observations for each bond in the estimation
instead partitioning bond data by year. Another dierence is in the estimation procedure: the original LOT
measure is estimated with maximum likelihood, while I use Markov Chain Monte Carlo (MCMC) techniques.
The estimates are averaged across ratings and and time to maturity. The table represents bonds that trade
at lease on 15% of the available trading days. The betas are the average estimated factor loadings. The
alphas are the average estimates of the positive and negative thresholds. The lot measure is the dierence
between the two thresholds, i.e. the sum of the buy-side and sell-side transaction costs. The table also
reports the number of bonds in each rating-maturity category.
AAA AA A BBB BB B CCC-D
Panel A: Short Maturity (1-2 years)
Bond Factor (
1
) -0.8173 -0.1906 -0.5428 -1.0091 0.5507 -1.1752 1.3262
Equity Factor (
2
) -0.0068 0.0368 0.0116 -0.0166 -0.7638 -0.3175 0.1451
Sell-Side Cost (
s
) -13 -60 -105 -116 -266 -301 -412
Buy-Side Cost (
b
) 12 55 102 111 206 218 369
LOT =
b

s
25 115 207 227 472 519 781
Num. Bonds 5 39 113 99 14 12 4
Panel B: Medium Maturity (3-10 years)
Bond Factor (
1
) -0.8532 -0.8301 -0.7423 -0.7964 -0.1801 -0.2858 -0.5793
Equity Factor (
2
) -0.0002 0.0070 0.0009 0.0103 -0.0136 0.0475 0.0618
Sell-Side Cost (
s
) -28 -73 -125 -199 -321 -502 -915
Buy-Side Cost (
b
) 26 69 117 189 307 475 856
LOT =
b

s
53 142 242 389 629 976 1771
Num. Bonds 7 36 106 57 12 15 11
Panel C: Long Maturity (more than 10 years)
Bond Factor (
1
) -0.5387 -0.6741 -0.5358 -0.6047 -0.2790 0.0155 0.0132
Equity Factor (
2
) 0.0051 0.0135 0.0049 0.0093 0.0215 0.0297 0.0043
Sell-Side Cost (
s
) -225 -257 -357 -399 -357 -370 -1159
Buy-Side Cost (
b
) 204 246 343 389 330 347 1075
LOT =
b

s
429 503 700 789 687 717 2233
Num. Bonds 4 8 54 50 17 27 7
46
Table 6: Stochastic Friction Model: Idiosyncratic Factors
This table presents average estimation results for the parameters in the return component (Equation (2.1))
of the model proposed in this paper. The results are categorized by (median) rating and (median) time
to maturity. In addition to the systematic bond market factors, a rm equity return and equity realized
volatility factor are included in the specication (Model 1). In the bottom panel (Model 2), I provide
estimates for a specication in which volatility is divided in its diusive and jump component. The last row
of each panel, i.e. LOT, is the time invariant component of the estimated round-trip liquidity costs (rst
part of the expression in Equation (2.5)).
AAA AA A BBB BB B CCC-D
Model 1: Realized Volatility
Short Maturity (1-2 years)
Bond Market -0.605 -0.484 -0.482 -0.475 -0.420 -0.430 -0.249
Firm Equity 0.002 0.003 0.003 0.004 0.004 0.007 0.023
Realized Volatility -0.001 -0.001 -0.001 -0.001 -0.001 -0.001 0.001
LOT =
b

s
103 268 393 414 451 383 382
Medium Maturity (3-10 years)
Bond Market -0.762 -0.677 -0.624 -0.549 -0.328 -0.300 -0.255
Firm Equity 0.003 0.002 0.002 0.003 0.006 0.007 0.014
Realized Volatility -0.001 -0.001 -0.001 -0.001 -0.002 -0.002 0.001
LOT =
b

s
146 211 311 398 409 350 373
Long Maturity (more than 10 years)
Bond Market -0.353 -0.320 -0.323 -0.333 -0.240 -0.081 -0.188
Firm Equity 0.002 0.005 0.002 0.003 0.005 0.010 0.005
Realized Volatility -0.001 -0.001 -0.001 -0.001 -0.002 -0.001 -0.002
LOT =
b

s
355 495 473 466 253 258 467
Model 2: Diusive and Jump Variation
Short Maturity (1-2 years)
Bond Market -0.609 -0.485 -0.483 -0.476 -0.420 -0.429 -0.245
Firm Equity 0.002 0.003 0.003 0.004 0.004 0.007 0.023
Diusive Variation -0.001 -0.001 -0.001 -0.001 -0.001 -0.001 0.001
Jump Variation 0.002 0.002 0.002 0.002 0.002 0.002 0.002
LOT =
b

s
103 265 390 411 447 380 380
Medium Maturity (3-10 years)
Bond Market -0.762 -0.679 -0.625 -0.550 -0.330 -0.300 -0.255
Firm Equity 0.003 0.002 0.002 0.003 0.006 0.007 0.014
Diusive Variation -0.001 -0.001 -0.001 -0.001 -0.002 -0.002 0.000
Jump Variation 0.002 0.002 0.002 0.002 -0.000 0.002 0.004
LOT =
b

s
145 210 308 395 406 347 369
Long Maturity (more than 10 years)
Bond Market -0.351 -0.320 -0.323 -0.333 -0.241 -0.081 -0.188
Firm Equity 0.002 0.005 0.002 0.003 0.005 0.010 0.005
Diusive Variation -0.002 -0.001 -0.001 -0.002 -0.002 -0.002 -0.002
Jump Variation 0.001 0.001 0.001 0.001 0.002 0.002 0.001
LOT =
b

s
352 490 468 462 251 256 462
47
Table 7: Stochastic Friction Model: Liquidity Costs
This table presents estimation results for the parameters of the threshold components (Equations (2.2) and
(2.3)) of the model proposed in this paper. The estimates are categorized by (median) rating and (median)
time to maturity. The time-invariant individual eects (Panel A) are allowed to respond asymmetrically
depending on whether observed reruns are negative (rst group of estimates) or positive (second group of
estimates). Panel B reports the sensitivity of liquidity cost to the time varying covariates, which include
calendar time (year dummies), age (year interval dummies), and the TED spread (dened as the dierence
between the 30-day treasury and eurodollar rates).
Model 1 Model 2
Posterior Percentiles Posterior Percentiles
Mean St Dev 1
st
99
th
Mean St Dev 1
st
99
th
Panel A: Time-invariant Covariates
Sell Side (
s
)
Intercept 1.638 0.304 0.940 2.349 1.630 0.304 0.913 2.343
Log Issue Size -0.541 0.022 -0.592 -0.490 -0.540 0.022 -0.591 -0.489
Coupon 0.126 0.017 0.087 0.166 0.125 0.017 0.085 0.165
Log Maturity -0.052 0.037 -0.136 0.036 -0.053 0.036 -0.136 0.032
Buy Side (
b
)
Intercept 1.718 0.315 1.004 2.456 1.708 0.311 0.979 2.431
LogIssue Size -0.555 0.023 -0.609 -0.502 -0.554 0.023 -0.606 -0.502
Coupon 0.138 0.018 0.097 0.180 0.137 0.018 0.096 0.178
Log Maturity -0.060 0.038 -0.149 0.030 -0.062 0.038 -0.147 0.025
Panel B: Time-varying Covariates ()
Calendar Year Eects (in terms of 2003)
Year 2004 0.080 0.005 0.069 0.092 0.079 0.005 0.067 0.089
Year 2005 0.097 0.006 0.086 0.112 0.095 0.005 0.084 0.105
Year 2006 0.111 0.006 0.099 0.126 0.108 0.005 0.095 0.118
Year 2007 0.171 0.007 0.157 0.190 0.167 0.005 0.154 0.179
Year 2008 0.142 0.008 0.126 0.161 0.137 0.006 0.124 0.154
Age Brackets Eects (in terms of [0, 3))
[3, 6) -0.004 0.008 -0.021 0.016 0.003 0.006 -0.011 0.017
[6, 9) -0.005 0.011 -0.029 0.020 0.005 0.006 -0.008 0.019
[9, 12) 0.014 0.012 -0.014 0.043 0.026 0.006 0.013 0.040
[12, 15) 0.034 0.015 -0.002 0.066 0.048 0.008 0.032 0.064
15 0.069 0.017 0.027 0.107 0.085 0.009 0.064 0.104
Ted Spread 0.017 0.002 0.012 0.021 0.017 0.002 0.012 0.021
48
Table 8: Yield Spreads Determinants: Univariate Analysis
Using bond data from TRACE from January 2003 to December 2008, I regress end-of-month credit spreads
on several liquidity measures, realized volatility, and credit ratings. The rst three models use three liquidity
measures: the percentage of zero trading days (over total trading days), the LOT measure, and the measure
proposed in this model (Rossi). In model 4 I regress credit spreads on realized equity volatility. In model 5 I
regress credit spreads on credit rating codes. In the last model I include both ratings and realized volatility.
In Panel A the regressors (except for ratings) and the regressand are in logs, while in Panel B they are in
levels. For the specications in levels the sample is trimmed and excludes the credit spreads below and above
the bottom and top percentiles respectively. The table reports OLS estimates and t-statistics in parenthesis.
Model (1) (2) (3) (4) (5) (6)
Panel A: Log Specications - Whole Sample
Intercept 0.12 -0.01 0.19 1.90 -1.15 0.22
( 11.84) ( -2.03) ( 24.78) (144.74) (-135.05) ( 13.20)
Pct Zeros 0.13
( 7.38)
Log LOT 0.27
( 62.12)
Log Rossi -0.00
( -0.78)
Log Realized Volatility 1.27 0.77
(138.27) ( 94.03)
Rating 0.17 0.13
(175.03) (134.18)
R
2
0.00 0.13 0.00 0.38 0.50 0.61
N 31173 26811 31173 31173 31173 31173
Panel B: Level Specication - Trimmed Sample
Intercept 0.10 -0.11 0.10 -0.59 -1.29 -2.20
( 10.99) (-17.20) ( 11.27) (-30.83) (-53.42) (-103.67)
Pct Zeros 0.15
9.08
LOT 0.07
( 64.03)
Rossi 0.02
( 9.36)
Realized Volatility 8.43 6.22
(147.45) (121.13)
Rating 0.41 0.29
(142.54) (115.94)
R
2
0.00 0.14 0.00 0.42 0.40 0.59
N 30577 26249 30577 30577 30577 30577
49
Table 9: Yield Spreads Determinants: Multivariate Analysis
Using data from January 2003 to December 2008, I regress end-of-month credit spread levels on several
determinants. The sample is trimmed and excludes credit spreads below and above the bottom and top
percentiles respectively. The table reports OLS estimates and t-statistics in parenthesis.
Regression Models
1 2 3 4
Liquidity and Volatility Measures
Pct Zeros 0.33
( 10.70)
Log LOT 0.13
( 14.77)
Log Rossi 0.10
( 8.44)
Realized Volatity 4.59 4.88 4.58 4.58
( 75.29) ( 74.00) ( 75.07) ( 74.89)
Credit Ratings (relative to AAA-AA)
A 0.05 0.01 0.05 0.03
( 0.87) ( 0.15) ( 0.93) ( 0.56)
BBB 0.45 0.38 0.45 0.41
( 6.83) ( 5.28) ( 6.83) ( 6.30)
BB 1.44 1.37 1.43 1.40
( 18.73) ( 16.41) ( 18.64) ( 18.20)
B or worse 2.15 2.06 2.14 2.11
( 26.19) ( 23.07) ( 26.00) ( 25.59)
Firm-specic/Accounting Variables
Pre Tax Int Cov [5,10) 0.12 0.12 0.12 0.12
( 3.68) ( 3.40) ( 3.75) ( 3.78)
Pre Tax Int Cov [10,20) 0.20 0.25 0.20 0.20
( 4.35) ( 4.93) ( 4.31) ( 4.36)
Pre Tax Int Cov [20,) 0.21 0.28 0.21 0.22
( 3.55) ( 4.26) ( 3.46) ( 3.70)
Inc to Sale -2.53 -3.42 -2.48 -2.40
(-11.97) (-13.53) (-11.76) (-11.39)
LT Debt to Assets -1.36 -1.35 -1.40 -1.29
( -7.59) ( -7.07) ( -7.76) ( -7.16)
Market Leverage 3.69 3.75 3.66 3.61
( 20.45) ( 19.70) ( 20.32) ( 19.98)
Macroeconomic and Other Variables
Treasury (1y) -0.54 -0.50 -0.53 -0.53
(-20.25) (-17.56) (-20.16) (-20.19)
Term Spread (10y-2y) -0.47 -0.40 -0.46 -0.47
(-10.68) ( -8.42) (-10.49) (-10.58)
TED Spread (30-day) -0.05 -0.07 -0.06 -0.05
( -3.66) ( -4.70) ( -3.77) ( -3.60)
Time to Maturity 0.01 0.01 0.01 0.01
( 17.17) ( 7.54) ( 18.02) ( 19.65)
R
2
0.51 0.52 0.51 0.51
N 30370 26105 30370 30370
50
Table 10: Yield Spreads Determinants: Clustered Standard Errors
Using data from January 2003 to December 2008, I regress end-of-month credit spread levels on several
determinants. The sample is trimmed and excludes credit spreads below and above the bottom and top
percentiles respectively. The table reports OLS estimates with t-statistics clustered by issuer.
Regression Models
1 2 3 4
Liquidity and Volatility Measures
Pct Zeros 0.33
( 5.41)
Log LOT 0.13
( 7.35)
Log Rossi 0.10
( 4.20)
Realized Volatity 4.59 4.88 4.58 4.58
( 7.91) ( 7.30) ( 7.88) ( 7.87)
Credit Ratings (relative to AAA-AA)
A 0.05 0.01 0.05 0.03
( 0.51) ( 0.08) ( 0.58) ( 0.37)
BBB 0.45 0.38 0.45 0.41
( 3.39) ( 2.46) ( 3.50) ( 3.22)
BB 1.44 1.37 1.43 1.40
( 4.22) ( 3.51) ( 4.24) ( 4.14)
B or worse 2.15 2.06 2.14 2.11
( 7.03) ( 6.53) ( 7.06) ( 6.95)
Firm-specic/Accounting Variables
Pre Tax Int Cov [5,10) 0.12 0.12 0.12 0.12
( 1.26) ( 1.18) ( 1.30) ( 1.30)
Pre Tax Int Cov [10,20) 0.20 0.25 0.20 0.20
( 1.07) ( 1.24) ( 1.06) ( 1.07)
Pre Tax Int Cov [20,) 0.21 0.28 0.21 0.22
( 0.99) ( 1.21) ( 0.97) ( 1.03)
Inc to Sale -2.53 -3.42 -2.48 -2.40
( -1.98) ( -2.21) ( -1.96) ( -1.89)
LT Debt to Assets -1.36 -1.35 -1.40 -1.29
( -1.38) ( -1.27) ( -1.42) ( -1.28)
Market Leveage 3.69 3.75 3.66 3.61
( 3.46) ( 3.41) ( 3.45) ( 3.39)
Macroeconomic and Other Variables
Treasury (1y) -0.54 -0.50 -0.53 -0.53
( -6.28) ( -5.10) ( -6.24) ( -6.27)
Term Spread (10y-2y) -0.47 -0.40 -0.46 -0.47
( -5.76) ( -4.40) ( -5.68) ( -5.75)
TED Spread (30-day) -0.05 -0.07 -0.06 -0.05
( -1.62) ( -2.03) ( -1.68) ( -1.60)
Time to Maturity 0.01 0.01 0.01 0.01
( 7.57) ( 3.26) ( 7.66) ( 9.69)
R
2
0.51 0.52 0.51 0.51
N 30370 26105 30370 30370
51
Table 11: Yield Spreads Determinants: Investment Grade Vs Junk Bonds
Using data from January 2003 to December 2008, I regress end-of-month credit spread levels on several
determinants. The sample is trimmed and excludes credit spreads below and above the bottom and top
percentiles respectively. The rst two regressions use the sub-sample of investment-grade bonds while the
last two regressions use only junk bonds. The table reports OLS estimates with t-statistics clustered by
issuer.
Investment Grade Junk
1 2 3 4
Liquidity and Volatility Measures
Log LOT 0.12 0.33
( 10.78) ( 4.14)
Log Rossi 0.09 0.10
( 6.23) ( 0.61)
Realized Volatity 3.62 3.50 6.92 6.57
( 12.46) ( 12.97) ( 9.09) ( 8.69)
Firm-specic/Accounting Variables
Pre Tax Int Cov [5,10) 0.10 0.08 0.33 0.52
( 1.07) ( 0.90) ( 0.85) ( 1.22)
Pre Tax Int Cov [10,) 0.06 -0.02 0.37 0.82
( 0.38) ( -0.11) ( 0.63) ( 1.36)
Inc to Sale -1.98 -0.93 -4.96 -5.71
( -1.47) ( -0.92) ( -1.44) ( -1.60)
LT Debt to Assets -1.74 -1.95 -6.68 -5.71
( -3.05) ( -3.42) ( -2.21) ( -2.04)
Market Leveage 3.11 2.97 8.10 7.74
( 2.67) ( 2.70) ( 3.02) ( 2.83)
Macroeconomic and Other Variables
Treasury (1y) -0.45 -0.46 -1.30 -1.38
( -9.36) (-10.43) ( -3.53) ( -3.28)
Term Spread (10y-2y) -0.65 -0.67 -1.62 -1.71
( -8.50) ( -9.24) ( -2.76) ( -2.65)
TED Spread (30-day) 0.29 0.30 0.24 0.26
( 8.39) ( 9.24) ( 2.14) ( 2.37)
Time to Maturity 0.01 0.01 0.00 0.01
( 4.21) ( 8.56) ( 0.15) ( 2.05)
R
2
0.47 0.46 0.57 0.55
N 22298 26086 3807 4284
52
Table 12: Yield Spreads Determinants: Pre-Crisis Vs Crisis
Using data from January 2003 to December 2008, I regress end-of-month credit spread levels on several
determinants. The sample is trimmed and excludes credit spreads below and above the bottom and top
percentiles respectively. The rst two regressions use the sample period going from January 2003 to December
2006 while the last two regressions use sample period from January 2007 to December 2008. The table reports
OLS estimates with t-statistics clustered by issuer.
Pre-Crisis Crisis
1 2 3 4
Liquidity and Volatility Measures
Log LOT 0.12 0.12
( 7.31) ( 3.55)
Log Rossi 0.07 0.14
( 3.29) ( 3.77)
Realized Volatity 2.62 2.31 4.88 4.67
( 4.47) ( 4.07) ( 6.68) ( 6.88)
Credit Ratings (relative to AAA-AA)
A 0.02 0.07 -0.85 -0.81
( 0.32) ( 1.19) ( -3.42) ( -3.34)
BBB 0.14 0.26 0.03 -0.06
( 1.02) ( 2.52) ( 0.06) ( -0.12)
BB 1.36 1.41 0.76 0.84
( 3.02) ( 3.22) ( 2.04) ( 2.27)
B or worse 1.77 1.88 3.37 3.29
( 7.02) ( 7.59) ( 4.17) ( 4.19)
Firm-specic/Accounting Variables
Pre Tax Int Cov [5,10) 0.22 0.16 -0.24 -0.00
( 2.38) ( 1.83) ( -0.27) ( -0.00)
Pre Tax Int Cov [10,20) 0.41 0.24 -0.66 -0.36
( 2.21) ( 1.55) ( -0.68) ( -0.41)
Pre Tax Int Cov [20,) 0.43 0.23 -0.04 0.33
( 1.92) ( 1.27) ( -0.03) ( 0.29)
Inc to Sale -3.76 -2.16 -0.04 0.23
( -2.22) ( -1.55) ( -0.01) ( 0.04)
LT Debt to Assets -0.59 -0.73 -1.03 -1.50
( -0.72) ( -0.92) ( -0.41) ( -0.62)
Market Leveage 3.61 3.60 4.85 4.96
( 2.98) ( 2.72) ( 2.04) ( 2.21)
Macroeconomic and Other Variables
Treasury (1y) -0.09 -0.10 -0.94 -0.97
( -1.42) ( -1.33) ( -7.82) ( -9.15)
Term Spread (10y-2y) -0.19 -0.21 -1.23 -1.28
( -2.05) ( -1.96) ( -6.16) ( -7.08)
TED Spread (30-day) -0.12 -0.11 0.06 0.07
( -1.90) ( -1.90) ( 2.38) ( 2.44)
Time to Maturity 0.01 0.02 -0.00 -0.00
( 5.13) ( 9.29) ( -1.18) ( -0.03)
R
2
0.17 0.14 0.57 0.56
N 18363 21361 7742 9009
53
Figure 1: Realized Volatility of Ford Motor Company
This gure shows the realized volatility (top panel) of the equity returns of Ford Motor Company. The
middle and bottom panel show the diusive and jump component respectively of the realized volatility. To
disentangle the diusive and jump variation, I use the ratio statistics RJ
it

RV
it
BV
it
RV
it
, which converges to
a normal distribution under the null hypothesis of no jumps.
54
Figure 2: LOT Model: Estimates Distribution
The upper row of the gure shows the distribution of the estimated factor loading (bond factor on the
left and equity factor on the right). The middle row presents the distribution of the negative and positive
thresholds (the negative of
s
on the left and
b
on the right). The last row report the distribution of the
estimates of round-trip transaction costs, given by
b

s
.
55
Figure 3: Idiosyncratic Volatility and Distribution of Factor Loadings
This gure reports the distribution of the estimated factor loadings of the friction model with idiosyncratic
risk and time-varying liquidity. The factors are (respectively from top to bottom) the market bond factor,
the individual equity return factor, and the individual equity return realized volatility factor.
56
Figure 4: Liquidity Measurers and Trading Activity
This gure reports scatter plots of the estimated liquidity cost measures from the LOT model and the model
that I propose versus the percentage of zero trading days, which is obtained dividing the number of days on
which a bond trades by the total available number of trading days.
57
Figure 5: Explanatory Power of Ratings and Realized Volatility
This gure reports several scatter plots of the log yield spreads on credit ratings (top) and realized volatility
(bottom). A linear and quadratic t (and their relative equations) are also included in the bottom panel.
Yield spreads are calculated as the dierence between corporate and treasury yields with similar character-
istics. Realized volatility is calculated (on a daily basis) with high-frequency data by squaring and adding
5-minute returns.
58