Stanislava Nikolova

Leverage Expectations and Bond Credit Spreads

In an efficient market, spreads will reflect both the issuer’s current risk and investors’ expectations about how that risk might change over time. Collin-Dufresne and Goldstein ( 2001 ) show analytically that a firm’s expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors’ expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.

The Transaction Costs of Trading Corporate Credit

To examine whether corporate credit risk is cheaper to trade in the bond or credit-default swap (CDS) market, we estimate individual roundtrip transaction costs for 851 CDSs traded during 2009-2014. Effective half-spreads are 14 bps of the notional amount for dealer-to-enduser and 12 bps for dealer-to-dealer trades for the most common notional traded,

Portfolio Similarity and Asset Liquidation in the Insurance Industry

2.5-7.5M. Cross-sectionally, effective spreads are weakly correlated with indicative quoted spreads, higher for more actively traded contracts, and related to reference obligation/entity characteristics. For institutional-size trades up to

Strategic Reporting of Fair Value Estimate Levels

500K, bonds are three times as expensive as the corresponding CDSs, but at larger trade sizes this pattern reverses.

Rethinking the Use of Credit Ratings in Capital Regulation

Insurance companies have been designated as Systemically Important Financial Institutions (SIFI) based upon the presumption that large insurers have similar portfolios and this similarity has the potential to affect the asset liquidation channel of systemic risk transmission. Analyzing a comprehensive dataset of both public and private insurance companies from 2002 to 2014, we construct a portfolio similarity measure using cosine similarity. We show that greater portfolio similarity between two insurers is significantly related to the similarity in insurers’ asset liquidation decisions and this relationship is only marginally related to whether or not insurer pairs are capital constrained. Potential SIFIs (insurers with

Momentum in Corporate Bond Returns

50 billion or more in consolidated assets), but not other insurers, with greater portfolio similarity of illiquid and downgraded securities have greater sales similarity during the financial crisis. This relationship remains strong even during the post-crisis period, providing support for the basis of their designation as systemically important. Our portfolio similarity measure provides information on the potential selling behavior of insurers over and above size and total sales. This work provides an implementable mechanism to identify and monitor the interconnectedness of insurer portfolios, thus helping regulators to identify asset liquidation channel vulnerabilities.

Market Discipline of U.S. Financial Firms: Recent Evidence and Research Issues

We examine whether fair value (FV) input levels and estimation sources are related to FV inflation, the difference between an insurers FV estimate and the consensus FV estimate across the securitys holders. FV inflation is higher, and self-estimation more likely, when insurers report using Level 3 inputs when the consensus level is 2. Regardless of the level, FV is greater when self-estimated. Public insurers that inflate FV through self-estimation potentially obfuscate detection by reporting the use of Level 2 inputs. Insurers with stronger incentives to appear financially healthy choose to self-estimate, resulting in greater aggregate portfolio FV inflation.

The Removal of Credit Ratings From Capital Regulation: Implications For Systemic Risk

We analyze an initiative by insurance regulators to rethink the use of credit ratings in assessing capital adequacy. The new regulations replace ratings with potentially more precise third-party estimates of expected credit losses and take into consideration an insurers current exposure to such losses when determining the appropriate capital charge. This change alleviates the need for insurers to rebalance their portfolios or raise equity to repair regulatory capital. After the change, insurers are less likely to sell distressed MBS, gains trade corporate bonds, or raise external financing. However, the new regime allows insurers to purchase more low-rated MBS at significant capital savings. Our analysis highlights some of the tradeoffs financial agencies should consider when implementing the Dodd-Frank mandate to remove credit ratings in financial regulations.We examine whether removing references to credit ratings from regulations, as mandated by the Dodd-Frank Act, affects the transmission of systemic risk through the asset liquidation channel. We analyze an initiative to reduce reliance on ratings for capital adequacy assessment in the insurance industry and its effect on insurers’ investment and financing decisions. After the change, insurers are less likely to repair regulatory capital by selling distressed MBS, gains trading corporate bonds, or raising external capital. However, the new regime allows insurers to purchase more low-rated MBS. Thus, the initiative may limit systemic risk transmission through the asset liquidation channel, but at the expense of more risk-taking than prudential regulators may prefer.