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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : Journal of Financial Economics, Volume 101, Issue 3, September 2011, Pages 596–620
This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. As insurance companies hold over one-third of investment-grade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties. Using insurance company transaction data, we find that insurance companies that are relatively more constrained by regulation are more likely to sell downgraded bonds. Bonds subject to a high probability of regulatory-induced selling exhibit price declines and subsequent reversals. These price effects appear larger during periods when the insurance industry is relatively distressed and other potential buyers' carpital is scarce.
This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Shleifer and Vishny (1992) show that forced selling of industry-specific assets may yield transaction prices that are significantly below fundamental values. In these circumstances, other buyers in the same industry may also face financial constraints and therefore be unable to provide liquidity. The presence of potential buyers is a crucial factor in determining the price at which any transaction will take place. As Pulvino (1998) argues, the maximum price that potential buyers are willing and able to pay for the asset depends on their own valuation and funding. As an interesting parallel among financial assets, the trading activity of bonds downgraded to speculative-grade by regulatory-constrained insurance companies provides an ideal environment in which to study forced selling and any associated price effects. As a group, insurance companies hold over one-third of outstanding investment-grade bonds (see Schultz, 2001) and, at the same time, face regulations that either prohibit or impose large capital requirements on the holdings of speculative-grade bonds.1 The empirical literature on asset fire sales provides several situations in which transaction prices may deviate from fundamental values.2Coval and Stafford (2007) study equity market transactions induced by open-end mutual fund redemptions. Mitchell, Pedersen, and Pulvino (2007) investigate the price reaction of convertible bonds around hedge fund redemptions. Pulvino (1998) studies commercial aircraft transactions initiated by (capital) constrained versus unconstrained airlines. Finally, Campbell, Giglio, and Pathak (2009) consider forced selling in the real estate market due to events such as foreclosures. In contrast, we examine a new channel that may induce fire sales: regulatory constraints. Specifically, regulations governing the investing behavior of insurance companies may effectively force the sale of certain assets (particularly those reclassified into a higher risk category) and simultaneously prevent other insurance companies from stepping in as buyers.3 As such, forced selling is most likely to occur in the downgraded bonds that are held by regulatory-constrained insurers such as those that have low risk-based capital ratios. Further, when coupled with a relative lack of liquidity, forced selling is likely to generate significant price pressure. To empirically test the fire sale hypothesis in the corporate bond market as related to regulatory requirements, we construct a data set of 1,179 bonds that were downgraded to speculative-grade over the period 2001–2005. We combine information on these bonds with observations on individual insurance companies' holdings and transactions provided by the National Association of Insurance Commissioners (NAIC). In addition, we obtain data on the financial position and strength of each insurance company from the Street.com. We employ an industry-standard risk-based measure to determine which individual insurance companies have the lowest risk capacity and are thus most likely (to have) to sell the downgraded corporate bond if the regulatory pressure hypothesis is valid. In studying the determinants of price patterns around corporate bond downgrades, we also use these constraint measures to make a distinction between trading volume arising from forced selling versus that which is discretionary. Finally, we use the overall distress in the insurance industry and the capital of potential buyers of speculative-grade bonds as time-conditioning variables to examine whether fire sales take place mostly in periods where sellers are under stress and buyers are hard to find. Several key empirical results deserve attention. First, we find that relatively constrained insurance companies are more likely to immediately sell (at least part of) their holdings of a downgraded corporate bond. Observable selling pressure varies with measurable differences in the financial health of the insurance companies holding these bonds. This result obtains even after controlling for insurance company and bond characteristics (e.g., such as the bonds' general level of liquidity). Second, we find that forced selling of downgraded bonds held disproportionately by regulatory-constrained insurance companies causes prices of these bonds to fall below fundamental values for several weeks around the downgrade event. Downgraded bonds largely held by relatively unconstrained insurance companies do not exhibit these dramatic price effects. Indeed, the median cumulative abnormal return differential across the two groups of bonds separated by the relative constraints of the bond holders is around −6% to −7%. As we observe that the relatively constrained firms have a larger probability of selling downgraded bonds, the evidence again points to a market imbalance generated by regulatory pressure. Further, prices fully revert by week +35, suggesting the imbalance is temporary. These are the key results of the paper. Why do these patterns exist and where are the potential buyers? Duffie, Garleanu, and Pedersen (2007) provide some recent theoretical guidance. They demonstrate that a market-wide liquidity shock that forces a large group of investors to sell a security, coupled with high search costs, can result in an extended period over which prices deviate from fundamental values. The speed with which transaction prices recover depends to a large extent on counterparty search costs and the associated level of market liquidity.4 In illiquid environments, a price recovery may take a significant period of time as market participants await sufficient counterparties. Since insurance companies face shared regulation, the resulting collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Fire sale prices will obtain, leading to transaction prices significantly below fundamental values. Liquidity provision, then, has to come from outside of the insurance industry. The gradual emergence of alternative investors in high search cost markets, like that for downgraded corporate bonds, will generate a slow reversal of transaction prices and an eventual realignment with fundamental values. In his AFA presidential address, Duffie (2010), provides a survey of recent research on these price effects across multiple markets associated with slow moving capital. Price pressures for downgraded bonds are expected to be larger when the insurance industry as a whole is in distress and/or when potential outside buyers' capital is relatively scarce. To explore this prediction, we measure selling pressure and price effect differentials across time periods. We find that the selling pressure around the bonds' downgrade and the associated price effects are more pronounced when (a) the insurance industry as a whole is in distress and (b) the capital of potential outside buyers for the downgraded bonds – such as high-yield mutual funds and high-yield and distress-focused hedge funds – is relatively scarce. Clearly, one important caveat is the fact that the fundamental value is not directly observable. Hence, measuring departures from fundamental values requires some explanation. Following Coval and Stafford (2007), we identify the fundamental value ex post by documenting the systematic patterns of transaction prices over time. Evaluating fundamental values in this way is admittedly complicated by the fact that the price effects that we find could be due to two alternative factors beyond the fire sales hypothesis. The first alternative is the information content of the credit rating change. To address this issue, we employ controls for the information contained in the downgrade by using bond-issuer stock returns around the event. Second, we also consider a sample of bonds issued by firms whose stock returns exhibit no significant reaction to the rating change in the spirit of Ambrose, Cai, and Helwege (2009). Arguing that these bond transactions are “likely to represent regulatory pressure rather than information-motivated trading,” they provide compelling evidence that price pressure is non-existent among this important subset of bonds. While this would appear to stand in contrast to our findings, the major difference between our paper and Ambrose, Cai, and Helwege (2009) is our principal focus on the cross-section and time-series as it relates to the financial health and regulatory constraints of the insurance companies holding the downgraded bonds. It is only because of the heterogeneity afforded by our use of individual insurance company data that we can identify fire sales. For this smaller sample, we continue to observe significant price effects for those bonds largely held by relatively constrained insurance companies; the differential median cumulative abnormal returns between bonds held by more or less regulatory-constrained insurance companies is around -4% in the first five weeks after the downgrade. In line with their conclusions, however, we find no significant price effects for bonds that are held by insurance companies that are not regulatory-constrained. The second factor relates to pure price pressure offered by Scholes (1972). Under this alternative explanation, transaction prices diverge from fundamental values because of an uninformed shock caused by either excess demand or supply. Providers of liquidity have to be compensated and this results in transaction price overshooting.5 Distinguishing between pure price pressures and fire sales is problematic because the two phenomena are not mutually exclusive. Our line of argument is that while price pressures can occur when corporate bonds are downgraded irrespective of the financial health of the investors holding them, fire sales should only occur when the bonds are disproportionately held by regulatory-constrained insurance companies that are forced to sell and potential buyers' capital is scarce, making it difficult to find a counterparty who is willing to pay competitive prices or who values downgraded bonds as much as the sellers. It is this dimension that we want to emphasize in this paper. The remainder of the paper is organized as follows. Section 2 discusses the sample construction and describes the summary statistics of the data. Section 3 provides results on how regulatory constraints at the insurance company level, insurance industry distress, and the scarcity of buyers' capital influence selling activity and price pressures around the downgrades. Section 4 presents cumulative abnormal returns and trading volume around the bond downgrades. Section 5 investigates several alternative explanations. Section 6 concludes.
نتیجه گیری انگلیسی
This paper investigates fire sales of corporate bonds by insurance companies. These companies operate under regulations that constrain their risk-taking capacity. An insurance company that faces binding regulatory constraints often has to sell some of its risky assets. Since insurance companies as a group hold over a third of outstanding investment-grade corporate bonds, any event that forces them to immediately and collectively sell the same bonds can induce a fire sale. We study the trading behavior of regulated insurance companies and the associated bond price patterns when investment-grade corporate bonds are downgraded to a speculative grade (a rating of BB+ or below). To empirically test the fire sales hypothesis, we construct a data set of all the corporate bond downgrades and individual insurance companies' positions and transactions from 2001 to 2005. The heterogeneity afforded by our use of individual insurance company data is fundamental to our analysis as it permits the disentangling of forced selling from other discretionary trades. In support of the hypothesized role for regulation, we find that regulatory-constrained insurance companies with, for example, low risk-based capital ratios are more likely to sell the downgraded bonds immediately after the downgrade. Also, we show that around the downgrade, the price deviations from fundamental values are significantly larger for bonds held widely by these constrained firms. For instance, the median cumulative abnormal returns in the first five weeks after the downgrade are almost −9% for bonds subject to high probability of forced selling but less than −3% for other downgraded bonds. This difference of about 6% disappears after 30 weeks. Finally, bonds downgraded during periods in which the insurance industry is under stress and the potential buyers' capital is relatively scarce experience a significant price discount to fundamental values. The conventional wisdom regarding corporate bond downgrades fails to reflect the critical role for the regulatory constraints faced by the individual insurance companies holding these downgraded bonds. Our tests all point to one conclusion: regulatory constraints imposed on insurance companies are important in explaining fire sales in the corporate bond market.