Illiquidity Spillovers from the Bond Market: The Effect of TRACE Coverage on Stock Liquidity

Abstract

Using a large sample of US corporate bond issuers, we empirically analyze the impact of TRACE implementation on stock liquidity. We propose two competing hypotheses: the transparency spillover hypothesis and the illiquidity spillover hypothesis. The transparency spillover hypothesis predicts that the increased post-trade transparency in the bond market due to TRACE enforcement has positive impact on the transparency of the stock market, resulting in higher stock liquidity. The illiquidity spillover hypothesis argues that stock illiquidity increases due to higher bond illiquidity, because TRACE reduces the dealers’ incentive to commit capital and provide liquidity in the bond market. We find strong support for the illiquidity spillover hypothesis. We use two standard measures of stock illiquidity, the Amihud illiquidity and the zero-return illiquidity, and we consistently find that TRACE coverage increases stock illiquidity. This relationship concentrates among high yield bond issuers. These findings are consistent with Zhang (2012) that TRACE coverage increases bond yield spreads because of the deterioration in bond liquidity. We also find that the effects of TRACE on stock illiquidity are significantly stronger among firms for which information efficiency in the bond market is more relevant, i.e., firms relying more on bonds in their debt structure, smaller firms, younger firms, firms listed on NASDAQ, and firms without banking relationships.

Keywords: TRACE, transparency, illiquidity spillovers, Amihud illiquidity, zero-return illiquidity

JEL Classification: C23, G01, G02