Downgrades, Dealer Funding Constraints, and Bond Price Pressure
50 Pages Posted: 1 May 2017 Last revised: 31 Jan 2019
Date Written: July 2018
Regulatory constraints imposed on insurance companies can induce a collective need to divest downgraded bond issues. Upon a downgrade, corporate bond dealers act as middlemen and provide liquidity by absorbing temporary order-flow imbalances. Limited access to inventory financing can temporarily limit dealers' inventory and risk-bearing capacities and, at least in the short run, impair liquidity provision. Using insurance company transaction data, I investigate if dealer funding constraints (as proxied by their CDS spreads) amplify price declines and stall subsequent reversals of downgraded bonds. I find that bonds handled by constrained dealers (with higher CDS spreads) are associated with substantially larger and abrupt declines and slower reversals of abnormal returns around a downgrade.
Keywords: Microstructure, Broker-Dealer Behavior, Event Study, Inventory Funding, Corporate Bonds, TRACE, NAIC, Financial Crisis
JEL Classification: G01, G14, G18, G22, G24
Suggested Citation: Suggested Citation