Liquidity Effects in Corporate Bond Spreads Summary - Essay Example

In contemporary investment besieged by potential financial risks, evaluation for higher market yields is imperative. Investments including corporate bonds inherently offer considerable higher yields though at a specified price. Persons investing in corporate bonds must understand that the investments have no collateral security but are inherently debentures. Moreover, investors or firms interested in the opportunity must consider the assumptions of credit risks and interest rate risks. Subsequently, it is imperative to note that credit spreads or financial benefits accruing from corporate bonds remains affected by liquidity and credit risks as aforementioned.

However, practical separation of the two fundamental factors is indescribable. Separation of the two fundamental factors during measurement of credit spreads and inherent risks associated with corporate bonds is domineering in understanding individual contributions amongst the two. However, comprehensive understanding of liquidity effects within a specified bond pairs traded by a firm on a given day assists in examining their spreads or yields. Liquidity proxies define the most effective technique of measuring liquidity effects and corporate bond spreads on a given pair of bonds from the same firm.

However, liquidity proxies have significant faults in determining the inherent effects requiring addition of clarifying power by incorporating other firms’ bonds. Matching bonds issued by the same firm helps in subduing credit risks and elaborating existing variation within bond spreads. Since liquidity proxies elaborates limited inherent variations in corporate spreads, it is essential to incorporate the aforementioned descriptive power through linking measurement to prices of other bonds within the diverse market.

Unreliability of liquidity proxies in providing spreads associated with corporate bonds prompts for further explanation and affirms that measuring bond spreads with liquidity proxies is inherently impossible.