Theory 03/The rival is a confound/Credit markets
Default Information or Liquidity?
The claim
Credit spreads predict default better than ratings because they aggregate dispersed information.
01The rival explanation
Spreads partly measure liquidity, and illiquid names trade at a premium that has nothing to do with default risk.
02What would tell them apart
Liquidity effects vanish when markets are stressed and liquidity is uniformly poor, while information effects should strengthen exactly then.
03Prediction
The predictive advantage should grow in stressed periods.
04Refutation
If the advantage disappears under stress, it was liquidity.