Greg Nini

Notes on Bonds: Illiquidity Feedback During the Financial Crisis

We address the connection between market stress and asset pricing by analyzing a large and systematic discrepancy arising among off-the-run U.S. Treasury securities during the crisis. We begin by showing that bonds traded for much less than notes with identical maturity and coupon. The gap exceeded five percent in December 2008. We then ask how the small differences between these securities, in particular their liquidity, could project to such a large gap in prices. We gauge the potential for bond-note arbitrage in two ways. First, with data on repurchase rates and fails, we highlight the frictions arbitrageurs encountered in funding a short position in the notes. Second, with daily transactions data on trades by insurance companies, who are large buy-and-hold fixed income investors, we relate demand for the expensive but liquid note to the cross section of insurers’ characteristics. The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia PA 19104. Department of Finance: David Musto, (215) 898-2323, musto@wharton.upenn.edu. Department of Risk & Insurance: Greg Nini, greg30@wharton.upenn.edu, (215) 898-0310. Department of Finance: Krista Schwarz, (215) 898-6087, kschwarz@wharton.upenn.edu. We are grateful to the Dean’s Research Fund of the Wharton School for data funding. We are particularly grateful to Michael Bulboff, who provided outstanding research assistance. All remaining errors are our own. Notes on Bonds: Liquidity at all Costs in the Great Recession Abstract: We address the connection between market stress and asset pricing by analyzing a large and systematic discrepancy arising among off-the-run U.S. Treasury securities during the crisis. We begin by showing that bonds traded for much less than notes with identical maturity and coupon, with the gap exceeding five percent in December 2008. We then ask how the small differences between these securities, in particular their liquidity, could project to such a large gap in prices. We gauge the potential for bond-note arbitrage in two ways. First, with data on repurchase rates and fails, we highlight the frictions arbitrageurs encountered in funding a short position in the notes. Second, with daily transactions data on trades by insurance companies, who are large buy-and-hold fixed income investors, we relate demand for the expensive but liquid note to the cross section of insurers’ characteristics. We address the connection between market stress and asset pricing by analyzing a large and systematic discrepancy arising among off-the-run U.S. Treasury securities during the crisis. We begin by showing that bonds traded for much less than notes with identical maturity and coupon, with the gap exceeding five percent in December 2008. We then ask how the small differences between these securities, in particular their liquidity, could project to such a large gap in prices. We gauge the potential for bond-note arbitrage in two ways. First, with data on repurchase rates and fails, we highlight the frictions arbitrageurs encountered in funding a short position in the notes. Second, with daily transactions data on trades by insurance companies, who are large buy-and-hold fixed income investors, we relate demand for the expensive but liquid note to the cross section of insurers’ characteristics.We trace the evolution of extreme illiquidity discounts among Treasury securities during the financial crisis, when bond prices fell more than 6% below more liquid but otherwise identical notes. Using high-resolution data on market quality and trader identities and characteristics, we find that the discounts amplify through feedback loops, where cheaper, less-liquid securities flow to longer-horizon investors, thereby increasing their illiquidity and thus their appeal to these investors. The effect of the widened liquidity gap on transactions costs is further amplified by a surge in the price liquidity providers charge for access to their balance sheets in the crisis. Received September 28, 2016; editorial decision January 2, 2018 by Editor Philip Strahan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Securitization and Capital Structure in Nonfinancial Firms: An Empirical Investigation

Contrary to recent accounts of off-balance sheet securitization by financial firms, we show that asset securitization by nonfinancial firms provides a valuable form of financing to shareholders without harming firms’ debtholders. Using data from firms’ SEC filings, we find that securitization is attractive to firms in the middle of the credit quality distribution, which are the firms with the most to gain. Upon initiation, firms experience positive abnormal stock returns, zero abnormal bond returns, and largely use the securitization proceeds to repay existing debt. Securitization helps minimize financing costs by reducing expected bankruptcy costs and providing access to segmented credit markets.

Special Purpose Vehicles and Nonfinancial Corporate Finance

We present novel empirical evidence on the use of off-balance sheet financing by publicly traded, U.S. non-financial firms. We find that about 5 percent of non-financial firms reported using a special purpose financing vehicle (SPV) to finance receivables in 2006. At the origination of the off-balance sheet financing program, firms experienced abnormal increases in stock prices on the order of 2 percent and experienced no change in bond prices. Compared with firms that do not use SPVs, users are larger in size, more likely to have access to internal and external financing, and have significantly more credit risk. However, users have less senior, secured bank debt in their capital structure; and nearly all users received explicit permission in a credit agreement to use off-balance sheet financing. The combined evidence suggests that off-balance sheet financing can reduce the cost of capital for a fairly unique set of firms that are relatively risky but do not rely on heavily on bank debt.

Congruence in Governance: Evidence from Creditor Monitoring of Corporate Acquisitions

We examine the impact of creditor control rights on corporate acquisitions, using covenant violations as an indicator of heightened creditor control. We show that private credit agreements frequently impose restrictions on borrower acquisition decisions. Following a covenant violation, creditors use their bargaining power to tighten these restrictions and limit acquisition activity, particularly deals expected to earn large negative announcement returns. Firms that do announce an acquisition while in violation of a covenant earn 1.8% higher stock returns, on average, with the effect concentrated among firms with weak external governance. We conclude that creditors and equity holders share congruent preferences to limit activity motivated by managerial agency conflicts.

The Risks and Returns of Corporate Loans

We study the risks and returns of syndicated corporate loans, which have become an actively managed asset class due to the emergence of nonbank institutional investors. We show that the returns to corporate loans have slightly negative interest rate duration and time-varying exposure to default risk. We estimate a regime switching model and show that shocks to default risk have a large impact on loan returns when leverage is high and a much smaller impact on loan returns when leverage is low, consistent with standard models of credit risk pricing. As a result, the systematic risk exposure of corporate loans increases following negative shocks to returns and decreases following positive shocks. This result has implications for portfolio allocation decisions, performance attribution, investor capital structure, and all other investment decisions that depend on the risks of the asset class.