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Explaining Bond Spreads Via Default Risk, Taxes, Rating Transition

and Liquidity

Dean Johnson and Howard Qi

Michigan Technological University

Abstract

This study develops a semi-structural framework of bond pricing that incorporates default risk, taxes, and bond rating transition, whereas prior papers have primarily focused on the first (and more recently the second) factor. After capturing the three effects, the remaining spread between corporate bond rates and risk free rates can intuitively be attributed to liquidity. Models estimated without all three effects cannot intuitively dismiss the "unexplained" spread as a liquidity premium. This is confirmed by applying the framework to samples from two periods (1973-1993, and 2004-2010).

JEL: G24, G30