Loan Trading and the Bond Market: The Information Asymmetry Dimension

Abstract

We use the US corporate loan and bond market to test the pricing implications of an informed investor – the lender – willingly renouncing to some of his informational advantage – by trading the loan and sharing sensitive information about the borrower with the market. We argue and show that the sale of the loan reduces adverse selection in the other publicly traded assets of the firm (bonds). We posit the existence of a flow of information between the lending arm of the financial conglomerate and its investment arm. We argue that the lender trades off the benefits of reducing its exposure to the cost of giving up some information. A sale of the loan, by increasing information in the market, reduces the informational advantage of the affiliated funds who will optimally reduce their stake in the bonds of the firm whose loans are sold, independently of considerations about the future value of the firm. The market understands these incentives and therefore reacts positively to the sale. We first show that yield spreads of the bonds of borrowers whose loans are sold drop around the loan sale. Thus, loan trading is good news for bondholders, either because they can learn directly from the information generated in the secondary loan market and/or because loan trading reduces the information asymmetry in the bond market. In support of the latter view, we find that, around the loan sale, (a) affiliated funds reduce their stakes in the bonds of the “sold borrowers”, (b) bond market liquidity improves and (c) short-selling demand for bonds is reduced. Loan sales and the accompanying holding reductions are not predictive of future bad financial conditions of the firm.