Negative Credit Spreads: Liquidity and Limits to Arbitrage

Abstract

Recent reports in the financial press regarding negative spreads in the investment-grade corporate bond market have drawn the attention of policy makers and market participants alike. Using a sample of investment-grade corporate bond yields for the period 9/2009 to 9/2010, the authors examine all data points where the trade price reflects a negative spread. There are a total of 67 instances distributed among 10 companies where the credit spread is negative based on reported trade prices. The observed credit spread does not violate arbitrage restrictions once the bid–ask spread and liquidity are accounted for. In terms of default risk, CDS prices are higher than the bond yield spread on these days, but funding and asset-specific liquidity constraints possibly limit the ability to exploit the arbitrage.