This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that corporate bond returns have significant exposures to fluctuations in treasury bond liquidity and equity market liquidity. Further, this liquidity risk is a priced factor for the expected returns on corporate bonds, and the associated liquidity risk premia help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.6 % per annum for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1.5 % per annum. We find very similar evidence for the liquidity risk exposure of corporate bonds for a sample of European corporate bond prices. ∗ We are grateful to Inquire Europe for financial support. We thank Viral Acharya, Michael

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Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. ISSN 1701-9397 2

financial support (SSHRC/Vice President’s grant). All usual disclaimers apply. SEGMENTED MARKET DIVERSIFICATION AND COST OF DEBT FINANCING The paper examines the cost of capital implications of geographic diversification in general and segmented market diversification in particular using a sample of corporate new bonds issued between 1999 and 2002 by non-financial U.S. parent firms. Consistent with the existing literature, the paper finds that geographically diversified firms obtain cheaper debt financing, compared to their domestic counterparts. In particular, U.S. firms benefit more from segmented market diversification. Firms diversified by segmented markets have lower cost of new debt compared to their counterparts diversified only by developed markets or operating domestically. In the panel tests, the paper reports that a US non-financial firm with an average level of segmented market diversification lowers its cost of new debt by about 31 basis points. This saving in cost of new debt is equivalent to a contribution to shareholder value of about 2.2 % of issued debt value. Debt ratings do not fully incorporate incremental information contained in the segmented market diversification by U.S. firms, while they do for the geographic diversification in general. About one third of the total yield spread impact