Regulatory Pressure and Fire Sales in the Corporate Bond Market
This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculative-grade bonds. As insurance companies hold over one third of all outstanding investment-grade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Using insurance company transaction data from 2001-2005, we find that insurance companies that are relatively more constrained by regulation are, on average, more likely to sell downgraded bonds. While many bonds do not exhibit a strong price response to the downgrade, those bonds subject to a high probability of regulatory-induced selling exhibit significant price declines and subsequent reversals. These price effects appear larger during periods in which insurance companies as a group are relatively more distressed and when other potential buyers’ capital is relatively scarce.
Fire sales, Regulation, Price pressure, Liquidity, Corporate bonds, Insurance companies
SMU Cox: Finance (Topic)