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Title: Time varying illiquidity of European corporate bonds Authors:  Ranko Jelic - University of Sussex (United Kingdom) [presenting]
Dietmar Maringer - University of Basel (Switzerland)
Xiaohua Chen - Bank of England (United Kingdom)
Wolfgang Aussenegg - Vienna University of Technology (Austria)
Abstract: Excess returns and time varying illiquidity are studied for 17 European corporate bond indices during 2000-2014. It is plausible that returns and illiquidity tend to vary over time depending on the state of the economy which in turn depends on some observable external conditions which are then reflected in the state-indicator. The above scenario can be modelled through a threshold regime switching (TS) model in which the transition mechanism is driven by observable state variables, and the transition between the regimes is abrupt at a threshold identified by the optimization procedure. We therefore develop a TS model with various candidate transition variables and a genetic algorithm that enables us to identify the most suitable factors that govern regime switches. We make a further methodological contribution by addressing model over-fitting by using the Bayesian Information Criteria. The results identify changes in realized stock volatility as the best transition variable. In a regime with low volatility, illiquidity levels and shocks are mostly insignificant. In a stress regime with increasing volatility, illiquidity bears the most significant impact on bond index returns. We find significant differences in the illiquidity effects across bond indices for different maturities, ratings and industries.