Regulatory Pressure and Fire Sales in the Corporate Bond Market

Abstract:     
This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculative-grade bonds. As insurance companies hold over one third of all outstanding investment-grade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Using insurance company transaction data from 2001-2005, we find that insurance companies that are relatively more constrained by regulation are, on average, more likely to sell downgraded bonds. While many bonds do not exhibit a strong price response to the downgrade, those bonds subject to a high probability of regulatory-induced selling exhibit significant price declines and subsequent reversals. These price effects appear larger during periods in which insurance companies as a group are relatively more distressed and when other potential buyers’ capital is relatively scarce.

Number of Pages in PDF File: 55

Keywords: Fire sales, Regulation, Price pressure, Liquidity, Corporate bonds, Insurance companies

JEL Classification: G11, G12, G14, G18, G22

working papers series