Liquidity Risk of Corporate Bond Returns

We study the exposure of the U.S. corporate bond returns to stock market and treasury liquidity risk over the period 1973 to 2007. We find that the liquidity risk of investment grade and speculative grade bond returns is intrinsically distinct. While in-vestment grade bond returns rise when stock- or treasury bond-market become illiquid, the speculative grade bond returns fall substantially. Importantly, this liquidity risk is regime-switching in nature with the liquidity betas, especially of speculative grade bonds, rising to extremely high values during times of high macroeconomic stress, illiq-uidity and volatility. These effects are robust to controlling for other systematic risks (term and default). The regime-switching model is able to predict the likelihood of be-ing in the high liquidity risk regime and explain realized bond returns with substantial accuracy in out-of-sample tests, including for the crisis period of 2008. Overall, the findings are consistent with a flight to quality during macroeconomic stress whereby investors prefer more liquid and safer assets to less liquid and riskier ones