This article investigates the role of liquidity risk in the momentum spillover from stocks to bonds by using a large data sample. The evidence strongly suggests that liquidity risk is an important determinant of momentum spillover returns. This finding is robust to controls for effects of trading liquidity, credit risk, behavioral factors, and bond characteristics. On average, liquidity risk explains about 40% of momentum spillover profits for investment-grade bonds and 55% for speculative-grade bonds over the 16-year sample period. A significant portion of momentum spillover returns can be viewed as compensation for investors’ exposure to liquidity risk when engaging in trading this anomaly.

This paper employs a new approach to estimating the size of liquidity premia in the credit default swap (CDS) and corporate bond markets. We develop a CDS pricing model with liquidity and default, and a corporate bond pricing model with default, taxes, and liquidity using the reduced-form approach, and jointly estimate parameters of both pricing models from pooled data using the generalized method of moments. By formulating default intensity as a common factor of the spreads of the CDS and reference bonds, we are able to identify the liquidity and other components of spreads more precisely. We find that both CDS and corporate bond spreads contain significant liquidity components. On average, the liquidity premium accounts for 13% of the CDS spread and 23% of the corporate yield spread. The size of the liquidity premium increases as the rating decreases. Estimates of liquidity premia in the CDS and corporate bond markets are highly correlated, and closely linked to bond-specific and aggregate liquidity measures. Results show that liquidity is important for CDS and corporate bond pricing. Ignoring CDS illiquidity results in a significant bias in estimation of corporate yield spread components when using the CDS information to aid in decomposition of spreads.

Using an aggregate credit spread index, we find that it has substantial predictive power for corporate bond returns over short and long horizons. The return predictability is economically and statistically significant and robust to various controls. The credit spread index and its components have more predictive power for bond returns than conventional default and term spreads. When decomposing the credit spread index into investment- and speculative-grade components, the latter has more predictive power for future bond returns. The source of the index’s predictive power is from its ability to forecast future economic conditions.