Corporate Credit Default Swap Liquidity and its Implications for Corporate Bond Spreads

The turn of the century has seen the development and growth of more efficient vehicles for transferring the credit risk of individual credit exposures or a portfolio of them. This growth has been fostered by the emergence of credit derivatives, in particular credit default swaps (CDSs). In a CDS trade, a credit protection buyer acquires credit protection from the counterparty by paying a premium. The CDS swap premium has been viewed as a clean representation of credit risk. As a result, in the past few years, researchers have used data on CDS trades where the reference entity is a corporation to study the liquidity component of corporate bond spreads. Using a transaction dataset, we discover very large bid-ask spreads in CDS quotes. With a two-factor model, we show that such large bid-ask spreads can profoundly affect the estimation of credit risk, which in turn has a significant effect on the estimation of the liquidity spread for corporate bonds. Contrary to the literature, we show that while the bond and CDS markets appear to have two different values for the credit spread, once liquidity is accounted for we no longer find such a difference