Working Paper

Insolvency or liquidity squeeze? Explaining very short-term corporate yield spreads

Abstract: In this paper, we first document some stylized facts about very short-term and long-term corporate yield spreads. We find that short-term spreads are sizable, and the correlations between many firms' short-term and long-term yield spreads are at times negative. We then develop a structural model that generates levels and correlations of short-term and long-term spreads that are more consistent with what we observe. The model allows for the possibility of payment delays when a firm's liquid asset position deteriorates. Payment delays generate sizable short-term debt spreads because the realized returns on short-term investments are very sensitive to an increase in the holding period. The presence of liquidity risk can also explain negative correlations between short- and long-term spreads because liquidity risk is imperfectly correlated with insolvency risk. Using firm-level data, we provide empirical evidence that liquid assets holdings help predict short-term spreads, but not long-term spreads.

Keywords: Corporations; Payment systems; Econometric models;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2002

Number: 2002-45