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Sovereign Debt, Default Risk, and the Liquidity of Government Bonds

The secondary market for sovereign bonds is illiquid and the liquidity is endogenous. Such endogenous liquidity has important e¤ects on the credit spread and the probability of default. To study equilibrium implications of such liquidity, I integrate directed search in the secondary market into a macro model of sovereign default. The model generates liquidity endogenously because investors in the secondary market face a trade-off between the transaction costs and the trading probability. This trade-o¤ varies with the aggregate state of the economy, creating a time-varying liquidity premium over the business cycle. I show that trade shows in the secondary market significantly affect the price of sovereign bonds and amplify the effect of default risk on credit spreads. The importance of liquidity in the secondary market increases when the economic conditions of the issuing country worsen. Illiquidity increases with default risk and accounts for a sizable fraction of credit spreads, ranging from 10% to 50%.