How a Credit Enhancement Affects Bond Liquidity and Default Risk of the Firm

The authors use a quasi- natural experimentto analyze the impact of a particular type of credit enhancement, a government guarantee, on bond liquidity and defaultrisk of the firm. They find that a guarantee (1) dramatically increases the liquidity of a bond, (2) generally reduces the defaultrisk of the firm and pre-existingbonds issued by the firm, and (3) increases the liquidity of pre-existingnon-guaranteed debt issued by the same firm. They find that the liquidity improvement caused by a guarantee reduces overall defaultrisk of the firms by 5.84%.