The Determinants of Liquidity in U.S. Corporate, Municipal, and Treasury Bond Markets.

We examine the determinants of the realized bid-ask spread in the U.S. corporate, municipal, and Treasury bond markets for the period 1995 to 1997, based on newly available transactions data. We find that the bid-ask spread is negatively related to a bond’s trading activity and positively related to its risk. In the corporate and municipal markets, the bid-ask spread increases in the remaining time to maturity and the credit risk. For corporate bonds, the bid-ask spread is concave in the time to maturity and increases in the age of the bond. In addition, the bid-ask spread is negatively related to the buy volume and positively related to the sell volume for corporate and municipal bonds, suggesting that the bond market may view sales as signals of adverse information about the bond. Consistent with this interpretation, the bid-ask spread is negatively related to the sell volume in the Treasury bond market. Further, volume is partly predictable, since only surprises in volume affect the bid-ask spread in the corporate and Treasury markets. We find that the bid-ask spread is not significantly different between the three markets, between large or primary market dealers and smaller dealers, and between large and small institutions. Finally, we examine why institutions sometimes trade without dealers, and find that the relative volume of directly negotiated trades in a bond decreases in its bid-ask spread, interest rate risk and adverse selection risk and increases in its activity level.