Index Driven Price Pressure in Corporate Bonds

Abstract

This study shows that the recent 80% decrease in dealer inventories of corporate bonds has increased the cost of immediacy. For safe bonds which are quickly turned over again by dealers the increase is up to 15%, while for risky bonds which are kept on inventory by dealers the increase is up to 100% on average. The time series of transaction costs is estimated using the natural experiment of corporate bond index exclusions. The exclusions are monthly and information-free events where index trackers seeking to minimize tracking error request immediacy in order to sell close to the exclusion date. The drop in dealer inventories, and thus the rise in transaction costs, is a side-effect of anticipated tighter regulation, primarily Basel III and the Volcker Rule.