In a recent study, Structural Changes in Corporate Bond Underpricing, we shed light on the allocation practices for US corporate bonds, and highlight their relation with the post-crisis environment, which is characterized by dealers facing tighter regulation due to the passing of the Volcker-Rule.
Our research focuses on two relatively understudied areas in finance, namely the allocation process of corporate bonds and the implications of post-crisis regulation. Despite the considerable size of the US corporate bond market ($ 8.2 trillion in 2015), little is known about the allocation process of bonds at issuance. The SEC itself has recently investigated the initial allocations of bonds among investors, requesting information from major underwriters including Goldman Sachs and Citigroup.
The aftermath of the financial crisis is characterised by significant changes in the structure of the corporate bond market. Being exposed to tighter regulation, dealers reduce their liquidity provisioning in the secondary market by committing less capital to inventory management. Furthermore, due to the low interest rates, many new firms approach the market and investors increasingly engage in ‘reaching for yield’.
In the US corporate bond market, underwriters are central: they provide placement services to firms and act as dealers between investors after bond issuance. We conjecture that the change in dealers' inventory management, driven by post-crisis regulation, affects the issuance process. Specifically, because dealers are more constrained and therefore offer less inventory in the secondary market, they have an incentive to place bonds to closely affiliated investors in the primary market in order to secure intermediation in new issuances. On the other hand, underwriter-affiliated investors accept this deal because they are rewarded through increased underpricing.
First, in our paper we document that average underpricing increases from 23 basis points (‘bps’) in the pre-crisis period to 64 bps after the crisis. Second, we find that, in the first quarter after issuance, institutional investors hold a higher fraction of a bond in the post-crisis (around 38%) compared to the pre-crisis period (around 27%), and that such increase is mainly driven by mutual funds. Third, we show that trading activity of newly issued bonds is up to three times higher in the post-crisis period compared to before.
In the main part of our analysis, we use a novel identification approach based on institutional investors' past holdings of bonds issued by underwriters to isolate the strength of underwriter-investor relations. We take the past holdings of the main investors in underwriters’ bonds as an instrumental variable for the initial allocation of newly issuances. This empirical strategy allows us to document that, in the aftermath of the crisis, underpricing increases because dealers systematically place bonds to closely related investors.
Furthermore, we show that underwriter-investor relations drive the increase in underpricing and trading activity at the same time. We find that the instrumented allocations fully explain both the difference in underpricing of 31 bps and the increase in trading activity of newly issued bonds between the pre-crisis and post-crisis period, respectively.
In summary, we provide novel insights into the determinants of corporate bond underpricing by elaborating on the role of underwriters and the investor base at issuance. Our results are of interest to both regulators and market participants alike. They deepen the understanding of how regulatory changes in the secondary market affect the incentive structures of intermediaries with respect to the initial allocation of bonds among investors.
Florian Nagler is an Assistant Professor of Finance at Bocconi University.
Giorgio Ottonello is a PhD Candidate at the Vienna Graduate School of Finance (VGSF).