The dynamics of market, credit and liquidity risk in the US corporate bond market

Market, credit and liquidity constitute important risk factors in financial markets. Investors looking for optimal combinations of risk and return have to monitor their portfolios with regard to each of those factors. This work brings answers to some of the challenges presented by these three risk factors in the US corporate bond market.
Market risk is the earliest and most widely acknowledged risk factor, affecting all financial securities. The risk that the issuer of the bond might go bankrupt introduces credit risk for corporate bonds. Finally, these securities are also characterized by a low trading frequency. Liquidity in this market has been severely affected by the recent global financial crisis as well as by the regulatory changes that followed the crisis.

The first part of this dissertation studies the return premium investors require in compensation for undertaking credit risk. It is shown that distributional characteristics of individual assets and in particular the contribution of an asset’s return to the market portfolio’s skewness and kurtosis are important determinants of these premiums. The second part explores commonality in individual bond liquidity levels. It is shown that the pricing of liquidity in yield spreads is essentially due to this commonality. The final part of this dissertation designs a corporate bond market index based on the repeat-sales technique. The index adequately captures aggregate market dynamics and contributes to the explanation of the cross-section of individual corporate bond returns.