Illiquidity or Credit Deterioration: A Study of Liquidity in the US Corporate Bond Market during Financial Crisis Nils Friewald · WU Vienna Rainer Jankowitsch · WU Vienna Marti Subrahmanyam · New York University Italian Treasury Tuesday, June 28th 2011 nyustern_logo.jpg (JPEG Image, 182x161 pixels) http://www.nyucareerstudy.org/nyustern_logo.jpg 1 of 1 03/15/2010 09:08 AM
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 2/28 Liquidity is an important price factor ◮ The financial crisis has shown that credit and liquidity risk are key determinants of asset pricing. ◮ It is important to understand their (relative) effects and how they change during periods of crisis. ◮ It is also relevant to ask if there are interactions between these important factors. ◮ The most affected financial markets were over-the-counter markets, which makes research challenging. ◮ The US corporate bond market is an ideal laboratory for testing as detailed transaction data (since 2004) are available. Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 3/28 Dramatic increase of average US corporate bond yield spread 10 8 GM/Ford Normal Sub−prime Crisis Period Crisis Spread in % 6 4 2 0 Jul 2005 Jul 2006 Jul 2007 Jul 2008 Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 4/28 What are we doing in the paper? ◮ We employ a wide range of liquidity proxies (bond characteristics, trading activity variables and liquidity measures) to explain yield spread (changes) while controlling for credit risk. ◮ We examine three different regimes in our sample period which allows as to compare liquidity effects during two periods of crisis (GM/Ford crisis, sub-prime crisis) with a more normal period in between. ◮ We analyze investment vs. speculative grade bonds to provide evidence whether liquidity is priced differently in these sub-segments. ◮ We use panel regressions and Fama-MacBeth regressions to analyze liquidity effects. Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 5/28 Relevant papers on liquidity Impact of liquidity on asset prices ◮ Amihud and Mendelson (JFE, 1986) → liquidity priced ◮ Amihud, Mendelson and Pedersen (FTF, 2006) → overview Evidence for corporate bond markets ◮ Longstaff, Mithal and Neis (JOF, 2005) → reduced-form models ◮ Huang and Huang (WP, 2003) → structural models ◮ Nashikkar, Subrahmanyam and Mahanti (forthcoming JFQA) → reduced-form models with bond-level liquidity Bond characteristics and trading activity ◮ Fisher (JPE, 1959) → first paper on liquidity effects in bonds ◮ Elton, Gruber, Agrawal and Mann (JOF, 2001) → explain part of the bond yield spread with credit and other factors ◮ Edwards, Harris and Piwowar (JOF, 2007) → analysis of bond liquidity Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 6/28 Relevant papers on liquidity Liquidity measures ◮ Roll (JOF, 1984) → Roll measure ◮ Amihud (JFM, 2002) → Amihud measure ◮ Chen, Lesmond and Wei (JOF, 2007) → LOT measure ◮ Mahanti, Nashikkar, Subrahmanyam, Chacko and Mallik (JFE, 2008) → latent liquidity ◮ Jankowitsch, Nashikkar and Subrahmanyam (JBF, 2011) → price dispersion measure Liquidity studies covering the financial crisis ◮ Bao, Pan and Wang (JOF, 2011) → focus on Roll measure ◮ Dick-Nielsen, Feldh¨ utter and Lando (forthcoming JFE) → various proxies Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 7/28 The three hypotheses that we test Hypothesis 1 Liquidity is an important price factor in the US corporate bond market. ◮ Amihud and Mendelson (1986) show that investors demand a premium for holding illiquid assets where there is a clientele effect. ◮ Duffie et al. (2007) find that liquidity premia are driven by transaction costs due to search frictions, inventory holding costs and bargaining power. Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 8/28 The three hypotheses that we test Hypothesis 2 Liquidity effects are more important in periods of financial distress. ◮ Duffie et al. (2007) demonstrate that in periods of crisis, liquidity is more important because inventory holding and search costs are higher, and asymmetric information becomes more relevant. ◮ Archarya et al. (2009) point out that banks face more stringent capital requirements when holding illiquid assets and access to liquidity is difficult. ◮ Sadka (2010) finds that during crises investors may have shorter horizons, e.g. to meet VaR requirements and margin calls. ◮ Bao et al. (2011) and Dick-Nielsen et al. (2010) also show that liquidity effects are more important during the sub-prime crisis. Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 9/28 The three hypotheses that we test Hypothesis 3 Liquidity effects are more important for bonds with high credit risk. ◮ Based on a regime switching model Archarya et al. (2009) show that liquidity is substantially different between investment and speculative grade bonds. ◮ Chen et al. (2007) find evidence that in periods of crisis, flight-to-quality effects are expected which result in lower price reactions for investment grade bonds. Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 10/28 Data sources Four different data sources ◮ Transaction data from TRACE ◮ Consensus market valuations from Markit ◮ Credit ratings from Standard & Poor’s ◮ Bond characteristics, swap and Treasury data from Bloomberg Merged data sample ◮ Period from Oct 1, 2004 to Dec 31, 2008 ◮ 3,261 firms ◮ 23,703 bonds ◮ 691,016 bond-weeks ◮ 23.5 mln trades Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 11/28 Set of proxies to capture liquidity Bond characteristics Liquidity measures ◮ Amount issued ↑ ◮ Amihud measure ↓ ◮ Coupon ↓ ◮ Price dispersion measure ↓ ◮ Age ↓ ◮ Roll measure ↓ ◮ Maturity ↓ ◮ Zero-return measure ↓ Trading activity variables ◮ Number of trades ↑ ◮ Trade volume ↑ ◮ Trading interval ↓ ↑↓ . . . expected effect on liquidity Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 12/28 Liquidity measures based on transaction data Washington Mutual Inc − CUSIP 939322AE3 (Jan 15, 2008) 100 ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● 98 ● ● Price ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● 96 ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● 94 ● 09:00 11:00 13:00 15:00 17:00 Trade Time Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
Motivation Literature Hypothesis Data Proxies Results Conclusion Appendix 13/28 Liquidity measures based on transaction data Omnicom Group − CUSIP 681919AT3 (Jan 15, 2008) 100 ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● 98 Price 96 94 09:00 11:00 13:00 15:00 17:00 Trade Time Marti Subrahmanyam Illiquidity or Credit Deterioration Tuesday, June 28th 2011
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