Was there a drop in liquidity in the corporate bond market during the Global Financial Crisis? It is often said that the increase in the perceived default risk led to a fall in the demand for the corporate bonds. This led to the fall in their prices and hence, their interest rates rose significantly. In fact, the risk and liquidity premium rose 360 basis points from 1.85% before the crisis to 5.45% afterwards. However, can we also attribute this fall in the demand for corporate bonds to a decrease in liquidity of these assets. It seems to make sense to say that as a result of there being less buyers, the market for these corporate bonds is thus less liquid. This decreased liquidity further diminishes the attractiveness of these assets, causing the demand for them to fall even more. I am asking if such a vicious cycle exists: Increased perceived default risk, leading to decrease in number of buyers, leading to decreased liquidity, leading to further decreases in the number of buyers, and so on?
&quot;...if such a...cycle exists...&quot;---i.e. in economic language, whether liquidity and demand are endogenous to each other. Yes, of course they are. Liquidity (or illiquidity) of any asset can be viewed as an equilibrium outcome where agents confirm each other's beliefs---similar to the liquidity/illiquidity of a bank. As such it has a self-fulfilling aspect. An asset is liquid because people believe it is and therefore are willing to trade/make markets for it. This in turn leads to demand for the asset, which makes it liquid.
There are many instances during the 2007-2008 Financial Crisis that illustrate this. In the US, the Fed took positions to restore confidence in illiquid markets. The Fed eventually took no loss on those positions. Of course, the Fed also took similar actions to prevent/stop runs on financial institutions.
There are also similar examples during the current Covid-19 episode. In March 2020, liquidity of corporate bond market returned as soon as the Fed announced its corporate bond purchase program---long before it was actually implemented. When the program was eventually implemented (which the Fed must, to signal its credibility), only a small portion of planned purchase was made. Market's belief in liquidity was maintained as long as the Fed is believed to be credible. (See also here.)