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By modeling debt rollover and endogenizing holding costs via collateralized financing, we develop a structural credit risk model to examine how the interactions between liquidity and default affect corporate bond pricing. The model captures realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, we simultaneously match the average default probabilities, credit spreads, and bid-ask spreads observed in the data. A structural decomposition reveals that the default-liquidity interactions account for 10∼24 % of the observed credit spreads. We apply this framework to evaluate the liquidity-provision policies in the corporate bond market.
Chen et al. (2017) studied this question.