Dynamic effects of idiosyncratic volatility and liquidity on corporate bond spreads

- Equity volatility and liquidity together matter for only distress bond portfolios.
- For all other bond portfolios only volatility matters.
- Volatility and liquidity shock impact on bond spreads went up during the crisis.
- Liquidity shocks are quickly absorbed into bonds prices.
- However, volatility shocks are more persistent and have a long-term effect.

We study the dynamic impact of idiosyncratic volatility and bond liquidity on corporate bond spreads over time and empirically disentangle both effects. Using an extensive data set, we find that both idiosyncratic volatility and liquidity are critical mainly for the distress portfolios, i.e., low-rated and short-term bonds; for others only volatility matters. The effects of volatility and liquidity shocks on bond spreads were both exacerbated during the recent financial crisis. Liquidity shocks are quickly absorbed into bonds prices; however, volatility shocks are more persistent and have a long-term effect. Our results overall suggest significant differences between how volatility and liquidity dynamically impact bond spreads.