Price Discovery in the Corporate Bond Market: The Informational Role of Short Interest
61 Pages Posted: 6 Nov 2011 Last revised: 20 Mar 2012
Date Written: March 13, 2012
This paper identifies a precursory role of short sellers in conveying adverse information to the corporate bond market. We study this in two ways, by examining subsequent calendar month excess (risk-adjusted) bond returns for portfolios formed on the basis of high short interest in a prior month, and by analyzing abnormal short interest and daily bond returns around earnings announcements. A zero-investment hedge portfolio of bonds based on the most and least extreme high short interest positions generates a statistically significant annualized excess return of 3.84 percent. Our findings are consistent with the view that short interest plays an informational role in setting bond prices. In the context of earnings announcements, this occurs because short traders benefit from useful information prior to a news announcement, possibly from leakage or private access, and perform a more rigorous analysis of the announcement itself, where such analysis is reflected in prices with delay. Taken together, these findings support the theoretical prediction of Diamond and Verrecchia (1987) that higher-levels of short interest convey unpublicized adverse information, thereby contributing to price discovery in securities markets.
Keywords: Short interest, corporate bonds, excess bond returns, Regulation SHO, price discovery, earnings announcements
JEL Classification: G12, G14, G24, M41
Suggested Citation: Suggested Citation