Rollover Risk and Corporate Bond Spreads

Abstract

This paper examines whether rollover risk is priced on corporate bond spreads. Using a novel data set and new proxies for rollover risk and market illiquidity, the empirical analysis developed reveals that market illiquidity affects corporate bond spreads beyond a liquidity premium through a “rollover risk channel”. This effect is statistically significant and financially important during episodes of market illiquidity, as in the recent U.S. subprime crisis, with speculative bonds and bonds issued by financial corporations being among the most affected. The results are significant even after controlling by a powerful set of variables and non-linear effects, are robust to alternative proxies of market illiquidity, bond and time-fixed effects, and potential endogeneity bias. This paper has important implications for the literature on the modeling of corporate bond spreads in periods of financial distress and in the current debate regarding the effects of financial crises and the regulation of financial corporations.

Keywords: Credit Spreads, Rollover Risk, Market Liquidity, Default Risk, Financial Crises

JEL Classification: G12, G13, G15, G32, G33