Abstract: 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 grade 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.

Abstract: We examine the optimal dynamic portfolio decisions for investors who acquire housing services from either renting or owning a house Our results show that when indifferent between owning and renting, investors owning a house hold a lower equity proportion in their net worth (bonds, stocks, and home equity), reflecting the substitution effect, yet hold a higher equity proportion in their liquid portfolios (bonds and stocks), reflecting the diversification effect Furthermore, following the suboptimal policy of always renting leads investors to overweigh in stocks, while following the suboptimal policy of always owning a house causes investors to underweigh in stocks For many investors, a house is the largest and most important asset in their portfolios The 2001 Survey of Consumer Finances (SCF) shows that about two-thirds of US households own their primary residences and home value accounts for 55% of a homeowner’s total assets, on average At the same time, approximately 50% of US households hold stocks and/ or stock mutual funds (including holdings in their retirement accounts), and stock investment accounts for less than 12% of household assets Even for households owning stocks, they account for less than 40% of household assets Housing differs from other financial assets in that housing serves a dual purpose It is both a durable consumption good from which the owner derives utility and also an investment vehicle that allows the investor to hold home equity Further, compared with other financial assets such as bonds and stocks, the housing investment is often highly

Abstract: Bond yields respond to policy decisions by the Federal Reserve and vice versa. To learn about these responses, I model a high‐frequency policy rule based on yield curve information and an arbitrage‐free bond market. In continuous time, the Fed’s target is a pure jump process. Jump intensities depend on the state of the economy and the meeting calendar of the Federal Open Market Committee. The model has closed‐form solutions for yields as functions of a few state variables. Introducing monetary policy helps to match the whole yield curve, because the target is an observable state variable that pins down its short end and introduces important seasonalities around FOMC meetings. The volatility of yields is “snake shaped,” which the model explains with policy inertia. The policy rule crucially depends on the two‐year yield and describes Fed policy better than Taylor rules.

Abstract: This paper examines whether there are efficiencies that benefit issuers and underwriters when a financial intermediary concurrently lends to an issuer while also underwriting its public securities offering. We find issuers, particularly noninvestmentgrade issuers for whom informational economies of scope are likely to be large, benefit through lower underwriter fees and discounted loan yield spreads. Underwriters, both commercial banks as well as investment banks, engage in concurrent lending and provide price discounts, albeit in different ways. We find concurrent lending helps underwriters build relationships, increasing the probability of receiving current and future business. FOR MANY YEARS, THE 1933 GLASS-STEAGALL ACT prevented commercial banks from underwriting corporate bonds and equities. Due to the relaxation and recent repeal of the Act, many commercial banks have acquired investment banks or developed investment banking capabilities internally to create universal banks that can offer an array of financial services. The entry of commercial banks into underwriting markets has increased the potential for financial institutions to offer both lending and underwriting services. In particular, it has become increasingly common for financial intermediaries to provide loans to a firm while also underwriting the firm’s public securities. In fact, concurrent lending and underwriting has increased substantially over time—in 1994, only 1% of seasoned equity issuers received a loan from their underwriter at around the time of issuance, but by 2001, over 20% of all deals were concurrent. The movement toward concurrent lending and underwriting raises a host of interesting questions. First, why are deals concurrent?

Abstract: We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor-changes in the federal funds rate target - and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a "current federal funds rate target" factor and a "future path of policy" factor, with the latter closely associated with Federal Open Market Committee statements.We measure the effects of these two factors on bond yields and stock prices using a new intraday data set going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

Abstract: This article provides an empirical decomposition of the default, liquidity, and tax factors that determine expected corporate bond returns. In particular, the risk premium associated with a default event is estimated. The intensity-based model is estimated using bond price data for 104 US firms and historical default rates. Significant risk premia on common intensity factors and important tax and liquidity effects are found. These components go a long way towards explaining the level of expected corporate bond returns. Adding a positive default event risk premium helps to explain the remaining error, although this premium cannot be estimated with high statistical precision. Compared to the extensive literature on risk premia in equity markets, relatively little is known about risk premia in corporate bond markets. Recent empirical evidence suggests that corporate bonds earn an expected excess return over default-free government bonds, even after correcting for the likelihood of default (see Section 1). In order to explain this excess return (or, equivalently, excess credit spread), existing research has looked at tax and liquidity effects, and risk premia on systematic changes in credit spreads (if no default occurs). However, a complete empirical analysis that incorporates all proposed components is lacking. The main contribution of this article is twofold. First, an empirical decomposition of expected corporate bond returns into the several proposed determinants—interest rate and default risk premia, and tax and liquidity factors—is provided. Second, this article is, to my best knowledge, the first to estimate the risk premium associated with a default event, and to assess its importance for expected corporate bond returns. This approach thus explicitly distinguishes the risk of credit spread changes, if no default occurs, from the risk of the default event itself. Estimation of the default event risk premium allows one to test the assumptions underlying the conditional diversification hypothesis of

Abstract: We develop a simple model of the effect of transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after the initiation of public transaction reporting through the TRACE system. The results indicate a reduction of approximately 50% in trade execution costs for bonds eligible for TRACE transaction reporting, and consistent with the model's implications, also indicate the presence of a liquidity externality that results in a 20% reduction in execution costs for bonds not eligible for TRACE reporting. The key results are robust to allowances for changes in variables, such as interest rate volatility and trading activity, which might also affect execution costs. We also document decreased market shares for large dealers and a smaller cost advantage to large dealers post-TRACE, suggesting that the corporate bond market has become more competitive after TRACE implementation. These results reinforce that market design can have first-order effects, even for sophisticated institutional customers.

Abstract: We consider nine different proxies (issued amount, listed, euro, on-the-run, age, missing prices, yield volatility, number of contributors and yield dispersion) to measure corporate bond liquidity and use a four-variable model to control for interest rate risk, credit risk, maturity and rating differences between bonds. The null hypothesis that liquidity risk is not priced in our data set of euro corporate bonds is rejected for eight out of nine liquidity proxies. We find significant liquidity premia, ranging from 13 to 23 basis points. A comparison test between liquidity proxies shows limited differences between the proxies.

Abstract: Expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist for long periods. Changes in investment opportunities can alter the risk–return trade-off of bonds, stocks, and cash across investment horizons, thus creating a “term structure” of the risk–return trade-off. This term structure can be extracted from a parsimonious model of return dynamics, as is illustrated with data from the U.S. stock and bond markets.

Abstract: The credit derivatives market provides a liquid but opaque forum for secondary market trading of banking assets I show that, when entrepreneurs rely on the certification value of bank debt to obtain cheap bond market finance, the existence of a credit derivatives market may cause them to issue sub-investment grade bonds instead and engage in second-best behavior Credit derivatives can therefore cause disintermediation and thus reduce welfare I argue that this effect can be most effectively countered by the introduction of reporting requirements for credit derivatives

Abstract: Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. We show that even were this the case, there remains a powerful argument for large-scale open market operations as a fiscal policy tool. As we also demonstrate, however, this same reasoning implies that open-market operations will be beneficial for stabilization as well, even when the economy is expected to remain mired in a liquidity trap for some time. Thus, the microeconomic fiscal benefits of open-market operations in a liquidity trap go hand in hand with standard macroeconomic objectives. Motivated by Japan’s recent economic experience, we use a dynamic general-equilibrium model to assess the welfare impact of open-market operations for an economy in Japan’s predicament. We argue Japan can achieve a substantial welfare improvement through large open-market purchases of domestic government debt.

Abstract: From a macroeconomic perspective, the short-term interest rate is a policy instrument under the direct control of the central bank. From a finance perspective, long rates are risk-adjusted averages of expected future short rates. Thus, as illustrated by much recent research, a joint macro-finance modeling strategy will provide the most comprehensive understanding of the term structure of interest rates. We discuss various questions that arise in this research, and we also present a new examination of the relationship between two prominent dynamic, latent factor models in this literature: the Nelson-Siegel and affine no-arbitrage term structure models.

Abstract: We solve the portfolio problem of a long-run investor when the term structure is Gaussian and when the investor has access to nominal bonds and stock We apply our method to a three-factor model that captures the failure of the expectations hypothesis We extend this model to account for time-varying expected inflation, and estimate the model with both inflation and term structure data The estimates imply that the bond portfolio of a long-run investor looks very different from the portfolio of a meanvariance optimizer In particular, time-varying term premia generate large hedging demands for long-term bonds

Abstract: Empirical evidence suggests that excess bond returns are forecastable by financial indicators such as forward spreads and yield spreads, a violation of the expectations hypothesis based on constant risk premia. But existing evidence does not tie the forecastable variation in excess bond returns to underlying macroeconomic fundamentals, as would be expected if the forecastability were attributable to time variation in risk premia. We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that several common factors estimated from a large dataset on U.S. economic activity have important forecasting power for future excess returns on U.S. government bonds. Following Cochrane and Piazzesi (2005), we also construct single predictor state variables by forming linear combinations of either five or six estimated common factors. The single state variables forecast excess bond returns at maturities from two to five years, and do so virtually as well as an unrestricted regression model that includes each common factor as a separate predictor variable. The linear combinations we form are driven by both "real" and "inflation" macro factors, in addition to financial factors, and contain important information about one year ahead excess bond returns that is not captured by forward spreads, yield spreads, or the principal components of the yield covariance matrix.

Abstract: The debate on government debt in the context of possible reforms of the international financial architecture has thus far focused on crisis resolution. This paper seeks to broaden this debate. It asks how government debt could be structured to pursue other objectives, including crisis prevention, international risk-sharing, and facilitating the adjustment of fiscal variables to changes in domestic economic conditions. To that end, the paper considers recently developed analytical approaches to improving sovereign debt structure using existing instruments, and reviews a number of proposals--including the introduction of explicit seniority and GDP-linked instruments--in the sovereign context.

Abstract: Macroeconomists want to understand the effects of fiscal policy on interest rates, while financial economists look for the factors that drive the dynamics of the yield curve. To shed light on both issues, we present an empirical macrofinance model that combines a no-arbitrage affine term structure model with a set of structural restrictions that allow us to identify fiscal policy shocks, and trace the effects of these shocks on the prices of bonds of different maturities. Compared to a standard VAR, this approach has the advantage of incorporating the information embedded in a large cross-section of bond prices. Moreover, the pricing equations provide new ways to assess the model’s ability to capture risk preferences and expectations. Our results suggest that government deficits affect long term interest rates, at least temporarily: (i) a one percentage point increase in the deficit to GDP ratio increases the 10-year rate by 35 basis points after 3 years; (ii) this increase is partly due to higher expected spot rates, and partly due to higher risk premia on long term bonds; and (iii) the fiscal policy shocks account for up to 13% of the variance of forecast errors in bond yields.

Abstract: The success of most of strengthening or retrofitting technologies for concrete structures by using external bonded FRP sheets depends highly on the interface bond between the FRP sheets and concrete substrates. This paper reviews current studies on evaluating the bond properties of FRP sheet–concrete interfaces and, in particular, focuses on several newly developed bond models for describing the bond characteristics of FRP sheet–concrete interfaces under various loading conditions. This paper also gives several examples that apply these interfacial bond models to the design of different retrofitting cases. Analytical solutions are discussed that consider the local interfacial delamination and slip behaviour, which can improve the prediction of strength and deformation performances, as well as clarify the failure mechanisms of concrete members upgraded with FRP composites. Moreover, the improvement in structural performance of retrofitted concrete members is discussed by relating them to the optimum microscopic properties of the interface bond and the properties of retrofitting materials.

Abstract: The naming of eleven banks as "too big to fail (TBTF)" in 1984 led bond raters to raise their ratings on new bond issues of TBTF banks about a notch relative to those of other, unnamed banks. The relationship between bond spreads and ratings for the TBTF banks tended to flatten after that event, suggesting that investors were even more optimistic than raters about the probability of support for those banks. The spread-rating relationship in the 1990s remained flatter for TBTF banks (or their descendants) even after the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), suggesting that investors still see those banks as TBTF. Until investors are disabused of such beliefs, investor discipline of big banks will be less than complete.

Abstract: International business research has paid scant attention to whether and how electoral politics and economic policies affect foreign investment risk assessment, particularly in developing countries, where the last decade has seen both considerable foreign investment and domestic progress toward democratization and electoral competitiveness. We respond with development and testing of a framework using partisan and opportunistic political business cycle (PBC) theory to predict the investment risk perceived by investors holding sovereign bonds during 19 presidential elections in 12 developing countries from 1994 to 2000. Consistent with our framework, we find that bondholders perceive higher (lower) investment risk in the form of higher (lower) credit spreads on their sovereign bonds as right-wing (left-wing) political incumbents appear more likely to be replaced by left-wing (right-wing) challengers. For international business research, our findings illustrate the promise of PBC theory in explaining the election-period behavior of sovereign bondholders and, perhaps, other investors who also ‘vote’ in developing country elections and can substantially influence the price and availability of capital there. For developing country investors and states, our findings highlight the financial effects of democracy in action, and underscore the importance of state communication with investors during election periods.

Abstract: International capital flows have increased dramatically since the 1980s, with much of the increase being due to trade in equity and debt markets. Such developments are often attributed to the increased integration of world financial markets. We present a model that allows us to examine how greater integration in world financial markets affects the behavior of international capital flows and financial returns. Our model predicts that international capital flows are large (in absolute value) and very volatile during the early stages of financial integration when international asset trading is concentrated in bonds. As integration progresses and households gain access to world equity markets, the size and volatility of international bond flows fall dramatically but continue to exceed the size and volatility of international equity flows. This is the natural outcome of greater risk sharing facilitated by increased integration. We find that the equilibrium flows in bonds and stocks are larger than their empirical counterparts, and are largely driven by variations in equity risk premia. The paper also makes a methodological contribution to the literature on dynamic general equilibrium asset-pricing. We implement a new technique for solving a dynamic general equilibrium model with production, portfolio choice and incomplete markets.

Abstract: We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model includes liquidity as a state factor. Using a unique transaction dataset, we estimate the liquidity risk of municipals and its effect on bond yields. Empirical evidence shows that municipal bond yields are strongly affected by all three factors. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium accounts for about 9–13% of municipal yields for AAA bonds, 9–15% for AA/A bonds and 8–19% for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in a severe underestimation of municipal bond yields. Conditional on the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and institutional investors. Furthermore, these implicit income tax rates are quite stable across bonds of different maturities. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle.