Understanding the Illiquidity of Corporate Bonds: The Arrival of Public News

Abstract
Whereas the illiquidity of corporate bonds is well recognized, its source is not well understood. In this paper, we use the arrival of firm-specific public news to gauge the importance of asymmetric information in shaping the illiquidity in corporate bond markets. We find that trading volume in corporate bonds increases by 21%; the reversal of shortterm bond returns decreases by 42% after controlling for the increase in volume; and the contemporaneous price impact of order flows decreases by 28% on days when public news arrives. Moreover, although large (small) buys of corporate bonds on average associate with higher (lower) future bond returns, such trades that occur on public news days have no return predictive power. Finally, firms with high news counts tend to issue bonds with yields 0.93% (1.28%) lower than firms with low (no) news counts. These results point to the notion that public news tends to resolve information asymmetry between informed and uninformed traders, thereby reducing the illiquidity in corporate bond markets.

Understanding the Illiquidity of Corporate Bonds: The Arrival of Public News [White Paper]

Introduction

Despite the enormous amount of corporate bonds outstanding, the U.S. corporate bond market is characterized with high illiquidity. In 2012 the average daily turnover in the corporate bond market is approximately one-third of that of the equity market. The illiquidity of corporate bonds has been shown to significantly impact firms’ cost of debt. Despite the importance of bond market illiquidity, factors that contribute to the corporate bond illiquidity remain poorly understood. In this paper, we empirically examine the importance of asymmetric information in determining the liquidity in corporate bond markets.

Theories that attribute illiquidity to asymmetric information have long been established. In pioneering microstructure models such as Glosten and Milgrom (1985) and Kyle (1985), the illiquidity of assets increases with the degree of information asymmetry between informed and uninformed traders. Empirically, there has been extensive evidence on the importance of asymmetric information on liquidity for equity market. (E.g., Easley et al., 1996).

Is asymmetric information important for bond market liquidity? On one hand, with predetermined cash flows, the value of bond bonds may be less sensitive to information than that of equity. On the other hand, corporate bond markets are dominated by institutional traders, and recent literature shows that institutional trading tends to be information driven (e.g., Barber et al., 2009). One appealing feature of corporate bond markets for informed traders is the inverse relation between trade size and trading costs, i.e., large bond traders tend to pay lower execution costs (Edwards, Harris, and Piwowar, 2007). If traders with private information prefer to act quickly on their information by placing large orders (Easley and O’Hara, 1987), the corporate bond markets may appear particularly attractive and the channel of asymmetric information could be important in shaping the illiquidity of corporate bonds.

To quantify the impact of information asymmetry on the illiquidity of corporate bonds, we use the release of firm-specific news as our identification strategy. Our key premise is that the release of firm-specific news can change firms’ information environment, resulting in changes in the degree of information asymmetry. Thus, studying patterns of bond trading and prices around public news release may offer an interesting setting to understand the effect of information asymmetry on liquidity.

Motivated by the theoretical microstructure literature, our paper examines various dimensions of corporate bond illiquidity including trading volume, the short-term reversal of corporate bond returns, and contemporaneous price impact of order flows. Among others, Wang (1994) shows that asymmetric information between informed and uninformed traders could generate an adverse selection problem, leading to reduced trading volume. Return reversal is also commonly used to capture illiquidity, with a stronger reversal reflecting higher illiquidity.

The source of liquidity-driven return reversal can arise from the channels of market maker’s inventory costs (risk) as well as information asymmetry. In the particular context of public news arrival, Tetlock (2010) builds on Wang (1994) and Llorente et al. (2002), and shows that the arrival of public news provides sunshine to liquidity-driven trades by informed traders. As a result of reduced information asymmetry, the cost of liquidity provision by uninformed traders declines and the return reversal is weakened. Our last measure of illiquidity is the price impact of contemporaneous order flow, or the Kyle’s (1985) lambda, It reflects the information content of order flows and is therefore a direct measure of asymmetric information component of illiquidity.

Our data combine a complete record of corporate bond trades as reported by the TRACE with a comprehensive firm-specific news data set from the Dow Jones News Wire in the period 2003—2011. We examine how corporate news arrival impacts the illiquidity of corporate bonds. Our tests show that the illiquidity of corporate bonds is substantially reduced on days with public firm news. First, trading volume in corporate bonds shoots up by 21% on days when firm-specific news arrives. Second, the reversal of short-term bond returns decreases by 42%, after controlling for the surge in trading volume. Finally, the contemporaneous price impact of order flows decreases by 28% on corporate news days.

Consistent with the intuition that bond values are more sensitive to credit-related and negative news, especially for high-yield bonds, we also find that the effect of public news on bond liquidity is stronger for credit-related news, negative news, and high-yield bonds. These results support the hypothesis that corporate news releases alleviate information asymmetry among traders, leading to reduced illiquidity of corporate bonds.

In theory, the illiquidity of corporate bonds can arise from channels other than asymmetric information. For example, if news releases generate more portfolio rebalancing trades from both buyers and sellers, market makers may incur a lower cost of inventory management, therefore quoting more favorable prices to bond traders. This in turn could lead to lower return reversal. To further validate the information asymmetry channel, we seek more direct evidence that public news release resolves information asymmetry among traders.

Specifically, we take advantage of two features of corporate bond markets. First, institutional bond traders tend to trade substantially larger amounts than individual bond traders due to the lower transaction costs enjoyed by the institutional traders. Therefore, we could relatively accurately categorize trades as institutional versus individual trades based on trade sizes. This has been more difficult for the equity market, where large investor orders are often broken up into small trades, which impounds noise into classifications based on trade size (Cready, Kumas, and Subasi, 2013). Second, unlike equity market, bond dealers are required to report trading direction information, making it possible to evaluate the information content of each trades executed with dealers.