We analyze determinants of secondary debt market liquidity, identifying conditions under which
a large investor can pro¯tably acquire large stakes and o®er ex post e±cient debt relief. Sec-
ondary debt markets can have multiple equilibria, with anticipation of low sales by small investors
inducing the large investor to curtail buying, and vice-versa. Further, debt markets are partic-
ularly prone to low-liquidity equilibria during recessions, when small investors face relatively
severe adverse selection. Debt sells at a discount in primary markets to compensate investors for
adverse selection and illiquidity. In contrast to debt, equity is always fairly-priced and perfectly
liquid in our framework, even with private trading by the large investor. Anticipation of low
liquidity equilibria in secondary debt markets results in higher yields and expected bankruptcy
costs, inducing discrete shifts into equity ¯nancing absent any change in economic fundamentals.