Does TRACE Coverage Reduce Corporate Yield Spreads?

Abstract

Using a large sample of US corporate bonds, we empirically analyze the impact of TRACE coverage on corporate yield spreads. We propose two competing hypotheses: the liquidity-enhancing hypothesis versus the liquidity-destroying hypothesis. The liquidity-enhancing hypothesis predicts that, due to increased transparency, TRACE coverage increases bond liquidity and therefore reduces bond yield spreads. The liquidity-destroying hypothesis predicts that TRACE coverage reduces the dealers’ incentive to commit capital to provide liquidity, resulting in lower bond liquidity and higher yield spreads. Our findings support the liquidity-destroying hypothesis and contradict the liquidity-enhancing hypothesis. We use two standard measures of yield spreads, the option-adjusted spreads and the asset swap spreads, and we consistently find that TRACE coverage increases corporate yield spreads. We show that this relationship is much stronger for high yield bonds than for investment grade bonds, and is largely driven by the illiquidity component of the yield spreads. The deterioration in bond liquidity in the secondary market also affects the primary market. We find that the TRACE coverage of existing bonds increases the offering yield spreads of new bond issuances.