David A. Lesmond

Corporate Yield Spreads and Bond Liquidity

We examine whether liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4000 corporate bonds and spanning investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads; and that an improvement of liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers’ fixed effect and potential endogeneity bias. Our finding mitigates the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants, and suggests that liquidity plays an important role in corporate bond valuation.

Liquidity and Credit Risk in Emerging Debt Markets

Liquidity risk is an important component of the yield spread on both corporate and sovereign bonds in emerging markets, explaining about half as much of the yield spread as credit risk specific variables. Using three measures of liquidity, including estimates from a model extension of the limited dependent variable model of Lesmond, Ogden, and Trzincka (1999)) on a dataset of over 1600 bond-years spanning both crisis and boom periods in 16 countries, we provide valuable evidence on the magnitude of these effects and the differences in liquidity across sovereign and corporate issuers. In particular, we document that liquidity components increase as credit quality deteriorates for sovereign debt, while the reverse is true for corporate debt, and are the first study to examine the determinants of the rapidly expanding emerging market corporate debt sector. Liquidity is highly significant in explaining cross-sectional variation in yield levels and changes across rated and unrated categories, for both corporate and sovereign issuers, and appears to dominate credit risk in explaining cross-sectional variations in yield spreads for both corporate and sovereign debt instruments across all of the emerging markets examined.

Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility Around the World

This paper examines data from 45 world markets and shows that the previously documented relation between mean returns and idiosyncratic volatility arises because of biases in volatility estimates that we can attribute to the bid-ask bounce in trade prices. We show that no significant relation exists between mean returns and idiosyncratic volatility estimated from quote-midpoint returns. Further, there is no significant relation between mean returns and the portion of transaction-price based idiosyncratic volatility that is orthogonal to bid-ask spreads. The pricing of idiosyncratic volatility is due to the negative pricing of the bid-ask spread.

What Drives the Trend and Behavior in Aggregate (Idiosyncratic) Variance? Follow the Bid-Ask Bounce

This paper models a market microstructure bias, driven by the bid-ask spread, that is evident in the aggregate firm-level risk embodied by the stock return variance estimates of Goyal and Santa-Clara (2003) and Campbell, Lettau, Malkiel, and Xu (2001). Controlling for this bias, we find that there is a significant liquidity channel through which most of macroeconomic policy and activity initially demonstrates an effect. Market microstructure also explains the time-trend of aggregate firm-level volatility observed from 1962 to 1997 (Campbell et al., 2001), and subsumes any relation between retail trading and future idiosyncratic volatility from 1983 to 1999 (Brandt, Brav, Graham, and Kumar, 2010). We conclude that the aggregate firm-level bid-ask spread better predicts future market volatility rather than any measure of economic activity and that the bid-ask spread is the primary driver in trends observed in aggregate volatility measures from 1927 to 2012.

Is Aggregate Idiosyncratic Risk Priced? Follow the Bid-Ask Bounce

This paper models a market microstructure bias, driven by the bid-ask spread, that is evident in the pricing of aggregate firm-level risk embodied by the stock return variance estimates of Goyal and Santa-Clara (2003). Controlling for this bias, we find no pricing ability for aggregate firm-level variance for the period 1927 to 2012 or for any sub-period tested. Market microstructure also explains the time-trend of aggregate firm-level volatility observed from 1962 to 1997 (Campbell, Lettau, Malkiel, and Xu, 2001), and subsumes any relation between retail trading and future idiosyncratic volatility from 1983 to 1999 (Brandt, Brav, Graham, and Kumar, 2010). We conclude that the aggregate firm-level bid-ask spread is priced with future market returns rather than any of the aggregate firm-level risk measures.