Uncertainty and liquidity in corporate bond market

Abstract

We examine the uncertainty–liquidity connection in the corporate bond market. Using monthly corporate bond data from 2005 to 2010, we construct proxies for parameter uncertainty by using firm-level parameters generated from a structural model of corporate debt. We find that uncertainty about firm parameters decreases trading volume but increases bid-ask spreads and price bouncing in the cross-section and across time. In addition, the panel VAR results show that parameter uncertainty has negative forecasting power for future bond liquidity, with greater uncertainty in the current month leading to lower trading volume, higher bid-ask spreads and higher price fluctuations on subsequent months. We conclude that parameter uncertainty is one of the underlying factors giving rise to the high level of illiquidity in the corporate bond market.