Downgrades, Dealer Funding Constraints, and Bond Price Pressure

50 Pages Posted: 1 May 2017 Last revised: 31 Jan 2019

See all articles by Andreas C. Rapp

Andreas C. Rapp

Board of Governors of the Federal Reserve System

Date Written: July 2018

Abstract

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

Rapp, Andreas C., Downgrades, Dealer Funding Constraints, and Bond Price Pressure (July 2018). Available at SSRN: https://ssrn.com/abstract=2960603 or http://dx.doi.org/10.2139/ssrn.2960603

Andreas C. Rapp (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://https://www.federalreserve.gov/econres/andreas-c-rapp.htm

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