US Corporate Bond Research Articles

Bond market structure and volatility

AbstractWe apply variance ratio methodologies to examine market quality in the US corporate bond market. We find that the open‐to‐open to close‐to‐close return variance ratio is greater than one suggesting that the corporate bond market is less efficient during the opening hours than during the closing hours. We show that the higher variance ratio at the open is related to the market power of dealers at the open and the sources of power are from lower cost of inventory, lower asymmetric information, and more flexibility to intermediate a trade. Dealers appear to exert less market power for bonds with low volume and credit rating. The results are consistent with dealers behaving strategically to unload risky assets and take on safer assets.

Corporate Bond Market Reaction to the Mandatory ESG Disclosure Act: Is Sustainium Sustainable?*

AbstractWe investigate the primary and secondary market reactions of US corporate bonds to the mandatory Environmental, Social, and Governance (ESG) Disclosure Act of 2021 (hereafter, the ESG Disclosure Act). We compare ESG bonds with non‐ESG bonds through a yield spread analysis for the primary market and a bond event study for the secondary market, assessing the impact on a sustainable premium (“sustainium”) following the enactment. Sustainium disappears from the primary market after the ESG Disclosure Act. Abnormal corporate bond returns in the secondary market are negative, and the impact on the sustainium is not economically different from zero. We also find that long‐term corporate bonds are more vulnerable to the ESG Disclosure Act. These findings indicate that investors should assess ESG bonds according to long‐term horizons if the sustainium is expected to persist.

Predicting Corporate Bond Illiquidity via Machine Learning

This paper tests the predictive performance of machine learning methods in estimating the illiquidity of US corporate bonds. Machine learning techniques outperform the historical illiquidity-based approach, the most commonly applied benchmark in practice, from both a statistical and an economic perspective. Gradient-boosted regression trees perform particularly well. Historical illiquidity is the most important single predictor variable, but several fundamental and return- as well as risk-based covariates also possess predictive power. Capturing nonlinear effects and interactions among these predictors further enhances forecasting performance. For practitioners, the choice of the appropriate machine learning model depends on the specific application.

Dealer inventory and the cross-section of corporate bond returns

We empirically study the role of dealers’ inventory risk in US corporate bond returns. To do so, we build a bond-level measure of exposure to inventory risk and find that the risk-adjusted return of a high-minus-low portfolio is 21 basis points per week. The inventory risk premium is amplified during times of crises, if hedging supply is low, as well as for bonds with higher credit risk. Our findings provide strong support for the asset pricing implication of inventory models and show that dealers use price pressure to compensate for bearing inventory risk.

Efficiency and sustainability of bond market: Evidence from aftermarket trading of US corporate bond offerings

We find that for bond offerings that are non-self-marketed, there is a significantly larger proportion of institutional-sized sell trades than buy. In stark contrast, for self-marketed offerings by underwriters, immediate post-offer trading is characterized by a larger proportion of institutional-sized buy trades than sell. We also find evidence suggesting that retail investors, who are initially shut out of the offering deals, buy bonds in the secondary market at a higher price. Our evidence suggests that certain institutional investors receiving allocations of non-self-marketed offerings flip them for a quick profit. The systematic disparity in aftermarket trading immediately following self-marketed versus non-self-marketed bond offerings suggests that the offering process is inefficient, which may have implications on the sustainability of bond offering process.

Deconstruction of ESG Impacts on US Corporate Bond Pricing: The Cost of Capital Benefits Across Industry Sectors

Deconstruction of ESG Impacts on US Corporate Bond Pricing: The Cost of Capital Benefits Across Industry Sectors

Procyclical Credit Rating Policy*

AbstractThis paper examines whether credit rating agencies applied consistent rating standards to US corporate bonds in the periods surrounding the 2008 financial crisis. Based on estimates of issuing firms' credit quality from a structural model, I find that rating standards are in fact procyclical: ratings are stricter during an economic downturn than during an economic expansion. As a result, firms receive overly pessimistic ratings in a recession, relative to during an expansion. I further show that a procyclical rating policy amplifies the variation in corporate credit spreads, accounting for, on average, 11% of the increase in spreads during a recession. In the cross‐section, firms with a higher rollover rate of debt, fewer alternative channels to convey their credit quality to the market, and firms with businesses that are more sensitive to economic cycles are more affected by the procyclical rating policy.

Lighting Up the Dark: Liquidity in the German Corporate Bond Market

We study market liquidity in the markets for German and US corporate bonds, providing a comparative analysis of liquidity in two over-the-counter (OTC) bond markets with different characteristics. We employ a unique regulatory dataset of transactions by German financial institutions from 2008 to 2014 to find, first, that overall trading activity is much lower in the German market than in the US. Second, much like in the US, the determinants of German corporate bond liquidity are in line with OTC-market search theories. Third—and surprisingly—frequently traded German bonds have transaction costs that are 39–61 basis points lower than a matched sample of bonds in the US. We relate our results to a number of structural market differences that may explain our findings, including differences in market structure, transparency, and the tax and legal environment.

Doing Well While Doing Good: The Elusive Quest for Green Bond Returns

In order to facilitate the transition to a low-emissions economic growth model, a burgeoning new “green finance” market has developed, providing ample opportunities for increasingly sustainability-focused investors. Using data for US and euro investment-grade corporate bond universes, this article seeks to analyze and quantify the investment relevance of green bond labels. The available empirical evidence points to three tentative conclusions: (i) labeled bonds tend to trade with slightly tighter spreads than conventional counterparts; however, this turns out not to matter for explaining total returns once typical measures of systematic credit risk are taken into account; (ii) contrary to common assertions, green bonds overall did not weather the COVID-induced sell-off in March 2020 significantly better than nongreen peers, and differences in performance between select green indexes and wider market benchmarks are largely attributable to compositional effects; (iii) EUR and USD green bond portfolios can be optimized to match the risk profiles of broad market benchmarks, while outperforming them in risk-adjusted terms.

Trade price clustering in the corporate bond market

PurposeIn this paper, the authors document the existence of price clustering in the US corporate bond market.Design/methodology/approachUsing a sample of 8,422,593 corporate bond trades in 2014, the authors find that over 18% (1,522,284 trades) of all bond trades end in a clustered price, defined as a price ending in 00, 25, 50, or 75.FindingsOverall, the authors find that both bond rating category and risk, as measured by standard deviation of prices, play a role in price clustering; speculative grade bonds account for the majority of clustered prices. Clustered prices are more likely to have higher coupon rates, higher prices, and higher standard deviations of price than bonds with non-clustered prices. Regardless of size, both buy and sell dealer trades with customers (relative to interdealer trading) lead to an increase in price clustering. Dealers appear to use clustered prices when purchasing from and selling to institutions and, therefore, may use a clustered price to insulate themselves from the risk of asymmetric information. Additionally, the prevalence of clustered prices for retail-sized dealer sell trades suggests that dealers exercise dealer power over retail-sized traders.Originality/valueThis paper contributes to the literature on price clustering by examining trade price clustering of corporate bonds. It is different from previous papers on price clustering in equities. Given that bonds tend to be priced off of yield, it is unusual that trade prices cluster. It also demonstrates what kind of bonds cluster and with which customers dealers trade at clustered prices. It parallels other research in demonstrating dealer power over retail-sized traders.

Generalizing the Sharpe Ratio and Infinite Divisibility in Financial Markets

Investments with high Sharpe ratios tend to be fixed income investments, particularly short-term bonds. Such securities dominate income investment, but not growth investment. We generalize the Sharpe ratio to interpolate smoothly between risk-averse and risk-seeking behaviors, with the traditional Sharpe ratio as a special case. The generalized ratios may be used to optimize portfolios within a lifestyle strategy or a lifecycle strategy. We demonstrate that the Sharpe ratio has an interpretation connected to value at risk (VaR), if returns are normally distributed. We study broad market indices and indicators for US stocks, US corporate bonds, gold, and Japanese stocks. Using monthly data obtained from FRED, we show that these datasets are neither normal, nor log-normal, nor stable. We argue that none of these distributions is appropriate for market data. We argue instead for using infinitely divisible distributions, and fit Pearson distributions to the data.

An Empirical Analysis of the Benefits of Corporate Bond Portfolio Optimization in the Presence of Duration Constraints

This article analyzes the out-of-sample performance of portfolio optimization models in the US corporate bond universe. In our empirical study, we measure the benefits of naive diversification and find that it eventually reaches a limit as the number of bonds increases. Also, we observe substantial improvements in the risk-adjusted performance of scientific portfolio constructions when compared to simple barbell strategies for the same given duration. When duration constraints are relaxed, we find that both naively and scientifically diversified portfolios outperform cap-weighted benchmarks in terms of Sharpe ratio.

‘Too central to fail’ firms in bi-layered financial networks: linkages in the US corporate bond and stock markets

Several measures have been recently developed in the financial networks literature to quantify the vulnerabilities of firms in specific markets for risk management. However, firms are often active in multiple asset markets simultaneously with potentially different degrees of vulnerabilities across markets. One can hypothesize that since assets are backed by similar firm-level fundamentals, the vulnerability measures across markets would be highly correlated. In this paper, we present two results based on the empirical correlation of network-based measures of vulnerabilities by studying US firms' asset returns that are active in stock as well as corporate bond markets. First, the magnitude of the relationship, while positive and significant, is not very large. Quantitatively, a unit percent increase in vulnerability measure of a firm in the stock market is associated with 0.15% increase in the vulnerability in the bond market. Second, the vulnerability of the firms in the stock market is negatively related to firm size proxied by market capitalization, indicating that ‘too-big-to-fail’ firms tend to be ‘too-central-to fail’. By adopting instrumental variables, we show that the coefficient has a higher magnitude. The results are robust with respect to choices of asset classes, maturity horizons, model selection, time length of the data, as well as controlling for return sensitivities to market-level factors.

The association between financial market volatility and banking market structure

We investigate whether banking market structure is associated with financial market volatility. A difficulty with achieving this task is the low frequency of the market structure data relative to the high frequency of volatility data. To overcome this problem, we employ a GARCH-MIDAS model that relates data with dissimilar frequencies. We employ both banking concentration and bank competition as measures of market structure. We find evidence that greater banking concentration is positively associated with higher volatility in the US stock, corporate bond, and Treasury markets, but no evidence of an association between banking competition and financial market volatility.

Collaboration, Adaptation, or Disruption? Wall Street, Fintech and Corporate Bond Trading

ABSTRACT Fixed-income corporate bond markets were the last bastion of non-electronic trading activity. For most of the twentieth century these markets were also dominated by the largest Wall Street dealer-banks. These banks had long argued that corporate bonds were too complex and illiquid to be electronified. In reality though, opaque Over-The-Counter trading in these bonds allowed Wall Street to monopolise highly uncompetitive markets; this market environment had changed very little over the decades, despite the financial services revolutions that had gripped other markets. By the 2010s however, Wall Street banks had finally begun to lose their stranglehold. This paper tracks the two explanatory factors, the emergence of new financial technology and the decisive intervention of state managers and post-crisis regulation – in the form of the Volcker Rule and Basel III. Recent accounts have become increasingly sceptical of the disruptive, pro-competitive impact of fintech. We argue that – at least in markets for US corporate bonds – there is evidence of a more competitive, democratic market environment emerging as a direct result of new financial technologies.

Make-wholes in sovereign bonds

Multiple researchers have observed a dramatic shift in US corporate bonds starting roughly in the mid-1990s and extending to the current period: from fixed premium call options to flexible rate call options.1 This flexible rate call provision was known initially as the ‘doomsday call’ and is now referred to as ‘make-whole’ call. It originated in the Canadian corporate bond market in the mid-1980s and migrated to the USA in the mid-1990s.2 Today, it is ubiquitous in the corporate bond market. A fixed premium call typically specified a percentage premium over the principal amount as a function of the remaining time on the bond (eg 110 per cent, if called five years prior to maturity year or 108 per cent if redeemed four years prior and so on).3 A ‘make-whole’ call, instead, measures the amount to be paid as a discounted value of future amounts, with the discount rate being a small spread over the prevailing risk-free rate (eg the discount rate might be the US Treasury rate plus 50 basis points).4

Causal nexus between crude oil and US corporate bonds

This study examines the Granger causal flow from implied oil volatility to US high-yield and investment-grade corporate bonds. The results show that the Granger causality differs over investment time horizons, with evidence of a more lasting effect for high-yield bonds. The oil price crash of mid-2014 intensifies the causal effect from oil price volatility to the high-yield bond market and its energy segment. Further analyses show that the US default risk and credit spread heterogeneously drive causalities from oil to high-yield and investment-grade bonds. These findings are useful to credit market participants for risk management and the design of appropriate asset allocation strategy. They are also important for policymakers regarding policy and regulatory formulations to manage the effects of volatility transmission.

Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation

This paper proposes a generalized bond pricing model, accounting for all the effects of credit risk, liquidity risk, and their correlation. We use an informed trading model to specify the bond liquidity payoff and analyze the sources of liquidity risk. We show that liquidity risk arises from reduced information accuracy and market risk tolerance, and it is market risk tolerance that links credit and liquidity. Then, we extend the traditional bond pricing model with only credit risk by incorporating liquidity risk into the framework in which the probabilities of the two risk events are estimated by a joint distribution. Using numerical examples, we analyze the role of the correlation between credit and liquidity in bond pricing, especially during a financial crisis. We document that the varying correlation between default and illiquidity explains the phenomenon of bond death spiral observed in a financial crisis. Finally, we take the US corporate bond market as an example to demonstrate our conclusions.

Sustainability premium in energy bonds

Abstract We investigate the extent to which belonging to a sustainable index leads to lower financing costs for companies in the energy industry. From an extensive sample that includes all energy bonds traded on the US corporate bond market between 2005 and 2014, we examine the differences between the yield spreads on bonds issued by green and non-green energy companies, based on the inclusion of issuers in the Dow Jones Sustainability Index. The yield spreads are computed from synthetic governmental bonds obtained discounting original cash flows from the zero-coupon yield curve. Controlling by bond fundamentals and market conditions, the sustainability premium averages 66 b.p. in yield spread terms. This premium depends on the credit quality of the issuer, ranging from 23 b.p. for investment grade bonds to 261 b.p. for junk bonds. This price premium that investors are willing to pay for the green energy company bonds entails a lower cost of debt for these companies.

Covenant Prices of US Corporate Bonds

This paper provides a novel approach to empirically determine prices of bond covenants based on transaction data for the US corporate bond market. Thereby, we are the first to measure price effects over the whole lifetime of bond contracts. We find that covenant prices vary significantly over time and are associated with changes in market-wide credit risk, volatility, and macroeconomic variables. During and after the financial crisis, this relationship is particularly pronounced leading to significantly higher covenant prices in the range of 5% of the overall bond yields. Apart from these time-series dynamics, there is also significant variation across bond and firm characteristics. In particular, covenant prices increase with interest rate, credit, and liquidity risk and are higher for firms that have more growth options, more tangible assets, and are smaller. Furthermore, we document a positive correlation between the prices of covenants and their subsequent inclusion rates.