Dealer Behavior and the Trading of Newly Issued Corporate Bonds

Transcription

1 April 2012 Dealer Behavior and the Trading of Newly Issued Corporate Bonds Michael A. Goldstein Babson College 223 Tomasso Hall Babson Park, MA Edith S. Hotchkiss Boston College Fulton Hall, Room 340 Chestnut Hill, MA (617) Abstract This paper provides some of the first evidence on the behavior of dealers trading in newly issued corporate bonds, based on a sample of 4,122 bonds issued from July 2002 to May We find that there is economically large underpricing for corporate bond issues, but that the measured underpricing reflects both the underwriters ex-ante pricing decision as well as price dispersion in after-market trading. Based on institutional sized trades (over 100 bonds), underpricing averages 45 basis points (BP) for investment grade and 124 BP for high yield offerings. Large institutions are net sellers of bonds in the initial days of trading, while smaller sized retail customers purchase bonds from non-syndicate member dealers at widely varying prices; small customers purchasing a bond on the same day from the same dealer frequently pay prices differing by over $2 (per $100 face amount). Finally, there is no evidence that dealers in newly issued bonds accumulate significant inventory positions, even when issues subsequently trade below the offering price. The authors are indebted to David Pedersen for extensive research assistance.

2 I. Introduction. The frequency with which firms issue public debt and the dollar magnitude of these issues is large relative to the heavily studied markets for public equity offerings. Despite the importance of this market for firm s cost of capital, there has been relatively little study of price and dealer behavior in this market. In this study, we examine a sample of 4,122 corporate bonds issued between July 2002 and May 2008, and show how price behavior in this market is related to characteristics of the dealers marketing and trading in these issues. 1 The availability of transactions price information to dealers and investors in U.S. bond markets has undergone significant changes in recent years. While corporate bonds have historically traded in an opaque dealer market without centralized reporting of trades, the information environment for trading these bonds began to change on July 1, 2002, when the National Association of Securities Dealers (NASD) initiated a program of increased post-trade transparency, known as the Trade Reporting and Compliance Engine (TRACE) system. The availability to us of transactions level data since the start of TRACE permits us to study behavior in this market at the dealer level. We first examine the overall liquidity of newly issued bonds. Interestingly, large institutions are net sellers of bonds in the first three days of trading, and subsequently become net buyers as trading volume declines over the subsequent days and months. Smaller retail investors, however, largely buy bonds in the first days of trading, and often do so at widely varying prices. Since the non-publicly disseminated TRACE data provided to us uniquely allows us to examine trades identified by dealer, unlike previous studies, we are able to measure dispersion as the difference in price paid across customer buys from the same dealer for the same 1 In this sense, our work parallels that of Ellis, Michaely and O Hara (2000), who provide the first transactions level analysis of dealer behavior for equity IPOs on Nasdaq. 1

3 bond on the same day. 2 Small customers often purchase the same bonds from the same dealer at prices differing by over $2 (per $100 face amount), though economically significant dispersion is also observed for institutional sized trades. The sales of bonds to smaller retail customers are frequently attributable to non-syndicate member dealers, who have purchased the bonds from institutional customers or in the interdealer market. We also find that measured price dispersion declines over time following the introduction of TRACE, though it increases again with the March 2007 onset of the financial crisis. 3 We then show that the corporate bonds in our sample exhibit significant underpricing, even when we account for the impact of price dispersion on measured underpricing. Underpricing is statistically and economically significant, averaging 45 basis points (BP) for investment grade and 124 BP for high yield offerings. 4 As a percentage of the offering amount, underpricing for bonds is smaller than has been widely documented for equity markets. However, given the large dollar size of many bond offerings and their relative frequency, the dollar amount of money left on the table is significant, and large relative to underwriter fees and other costs of the offering. We also provide evidence of a reduction in underpricing and price dispersion over time subsequent to the July 2002 introduction of TRACE. Whether these gains are potentially passed on to issuing companies, however, is less clear, as non-syndicate 2 The transactions data used for this study include an anonymous dealer code, enabling us to group trades by dealer. 3 Green, Hollifield and Schurhoff (2007b) show that in the municipal bond market, price dispersion is largely due to small trades which occur at a wide range of prices almost simultaneously. Similarly, Goldstein, Hotchkiss and Sirri (2007) show the presence of a substantial number of outliers in price within the TRACE data, suggesting that customers trading near in time often pay (or receive) widely differing prices. In his AFA Presidential address, Green (2007) models the dealer behavior leading to observed price dispersion when there is a lack of transparency in secondary markets. An important implication of his model is that dealers ability to discriminate between informed and uninformed customers is reduced with the introduction of transparency. 4 Cai, Helwege & Warga (2006) examine trades by insurance companies and find no significant underpricing for investment grade bonds and underpricing averaging 47 BP for high yield issues. Datta, Iskandar-Datta and Patel (1997) examine first time bond offerings of 50 issuers and find underpricing of 1.86% for high yield issues and overpricing of 2.88% for investment grade issues. Kozhanov, Ogden and Vaghefi (2011) argue that corporate bonds are overpriced at issuance. 2

4 member dealers account for a significant proportion of the trading activity and price dispersion in the after-market for newly issued bonds. Theoretically, the impact of transparency on underwriter s ex-ante pricing decision is not clear. If agency problems between the underwriter and issuer are important, underpricing may increase to offset reduced profits from trading in the transparent after-market. 5 Unlike equities, underwriters may also retain significant inventory risk in corporate bonds, particularly when an offering proves difficult to place. Increased underpricing would reduce this risk to the underwriter. In contrast, if underpricing is compensation for the risk that the security will be illiquid after issuance as in Ellul and Pagano (2006), underpricing may decrease if transparency is associated with improved after-market liquidity. Further, under transparency, investors can observe transactions prices for similar, previously issued bonds then trading in the aftermarket. To the extent this reduces information asymmetries for the bond being issued, underpricing may decrease. 6 While we do not attempt in this paper to resolve the large and ongoing debate between potential explanations for underpricing, we do provide evidence for the overall impact of the change in the information environment on pricing and dealer behavior. Our results are consistent with a reduction over time in dealers local monopoly power, resulting in less price dispersion and therefore lower measured underpricing, not including the notable market break in 2007 and We find no evidence that there is any increase in ex-ante underpricing related to the introduction of transparency; more likely, there is a decrease. Further, we find no evidence that dealers accumulate significant inventory positions, even when issues subsequently trade below 5 Papers by Bessembinder, Maxwell and Venkataraman (2007), Goldstein, Hotchkiss and Sirri (2007), and Edwards, Harris and Piwowar (2007) find evidence of reduced effective spreads associated with the introduction of transparency under TRACE. Reduced price dispersion will also lower measured dealer profits. 6 Models of underpricing based on asymmetric information include Rock (1986) and Benveniste and Spindt (1989). Ljungqvist (2004) provides an extensive review of empirical studies of underpricing in equity IPOs. 3

5 the offering price. 7 This finding is inconsistent with the idea that underpricing increases to offset the risk that dealers might accumulate large inventory positions in the event of price declines in the after-market. Our paper also provides some of the first available descriptive evidence for trading activity in newly issued bonds. Contrasting our results with those previously documented for equity offerings allows us to consider whether the dealer behavior and trading activity we observe is specific to bond markets, characteristic of dealer markets, or is more generally true for new public issues of securities. Our descriptive evidence can be summarized as follows: For each type of dealer (bookrunner, other underwriters, non-underwriters), trading volume is considerably higher on the first 2 days of trading. After day 2, volume continues to fall very slowly over the first 60 days and continues to fall over the next four months. Bookrunners and other managers market shares of volume fall after the first day of trading, and then remain somewhat constant. After the first week of trading, nonunderwriters market share of volume reaches just under 45% of total trading activity based on the dollar volume of trade and nearly 60% based on the number of trades. A large number of retail investors purchase bonds, and their entrance increases on the third day of trading. 8 Sales by these investors are significantly smaller in number (approximately 5% to 10% of the number of buys). The remainder of this paper proceeds as follows. Section II describes our sample construction and provides descriptive statistics for trading activity in the newly issued bonds. Section III focuses on dealer behavior leading to price dispersion, and examines how the 7 We again do not include data from 2007 and 2008 to avoid issues related to the credit crisis. 8 We define retail trades as trades of less than 100 bonds. See footnote 17 for further explanation. 4

6 potential change in dealers market power due to the introduction of transparency is reflected in the dispersion observed. Section IV describes the extent of underpricing and the relationship between this underpricing and transparency. Section V examines how dealer inventory behavior is related to the initial bond returns. Section VI concludes. II. Sample description and trading activity for new issues. With the July 2002 introduction of TRACE, all NASD (now FINRA) members were required for the first time to report prices, quantities, and other information for secondary market transactions in corporate bonds. Public dissemination of this trade information was phased in over time based on the bond s issue size and rating, allowing us to observe the relationship between transparency and liquidity at each phase. Our dataset includes all trades reported to TRACE in both opaque (pre-transparency) and transparent regimes, as well as all trades on 144A bonds which are reported to FINRA but remain non-transparent. The timing of reporting and dissemination rule changes is important to our regression specifications and interpretation of the effects of time periods and transparency. A brief chronology is provided in Table 1. As of July 2002, trade information was collected by FINRA but only publicly disseminated for investment grade bonds (rated BBB and above) with issue sizes greater than $1 billion. In March 2003, dissemination was expanded to include all bonds rated A or above with issue sizes greater than $100 million. In October 2004, dissemination was expanded to include bonds rated BBB and below, with the exception of bonds which did not meet a trading frequency threshold. However, dissemination of trade information for newly issued bonds was delayed until day 3 of trading for BBB bonds, and until day 11 for lower grade 5

7 bonds. 9 Lastly, on January 9, 2006, these delays were removed and trade information became disseminated for all non-144a corporate bonds. We divide our full sample period into subperiods based on these changes, and a final period beginning March 2007 which corresponds to the onset of the financial crisis. Our sample of newly issued bonds includes all TRACE eligible bonds issued between the July 2002 start of TRACE and May 2008 for which issuance information could be verified from Mergent. This verification is done to accurately determine the first date on which trading can begin, even when trades are not in fact observed in TRACE. We eliminate bonds issued in an exchange or reorganization, medium term notes, foreign issues, and convertible bonds, and include only bonds sold via a negotiated offering. We also retain only bonds for which the identity of members of the underwriting syndicate is available from Dealogic. Finally, we restrict our analysis to bonds which have at least ten trades in the first 20 trading days following issuance. This produces a final sample of 4,122 newly issued bonds from 1,764 issuers. While one issuer has 42 bonds in the sample, 54% of issuers have only one bond included and 84% of issuers have 3 bonds or less. Results reported in this paper do not significantly change when we exclude issuers with more than three bonds. Characteristics of the sample of new issues are shown in Tables 2a and 2b. Issue sizes are predominantly between $100 and $500 million (the mean and median issue sizes are $515 and $350 million, respectively, with a minimum issue size of $25 million). A large proportion of issuers are financial companies. While the volume of issuance is heaviest in 2003 and the first half of 2007, there are no substantial time concentrations of concern. Despite a decline with the 9 While the dissemination delays on less actively traded bonds were changed in February 2005 to apply only to trades over $1 million, the delays in dissemination of newly issued bonds remained. 6

8 onset of the financial crisis, the number of issues remains substantial relative to earlier time periods. Rating category definitions follow the TRACE dissemination guidelines, using the lower of the S&P or Moody s rating at issuance. More than half the sample (60.6%) is investment grade bonds (non-rated bonds are included with high yield). Only 113 of the 1,625 high yield bonds are subject to immediate dissemination at issuance; this is because trades in high yield bonds are not disseminated until later in the sample period and because high yield bonds are predominantly issued as 144A offerings, the only type of corporate bonds not currently subject to dissemination under TRACE. To begin to understand the behavior of participants in this market, we report aggregate trading volume over the first month of trading in Table 3. Only secondary market trades (not the primary offering) are reported to TRACE during this time period. However, in the event a dealer holds bonds in inventory beyond the offering date, subsequent sales of those bonds may be included in TRACE. 10 We divide trades into size groups of greater than 100 bonds and less than or equal to 100 bonds, since small trades are predominantly those of retail investors. 11 The TRACE data provided to us further classifies trades as interdealer trades, customer buys from a dealer, or customer sales to a dealer. Retail size trades account for a small proportion of the face amount traded, but a much larger proportion of the number of trades. For example, purchases of 100 bonds or less by customers on day 1 account for only $146 million in trade volume, but 10 Unlike equities, an underwriter for a non-convertible 144A or investment grade offering may begin trading in the secondary market while still holding a portion of their initially allocated bonds (SEC Rule 10b-6 and Regulation M ). Rules for trading in high yield non-144a bonds correspond more closely to those for equities. 11 Based on discussions with market participants, it is widely held that trades of more than 100 bonds are institutional trades, while smaller trades are likely from retail accounts. This separation is further supported by analysis done by a large clearing firm, showing that trades of 50 or fewer bonds almost entirely involve retail investors. For our purposes, we assume that trades between 50 and 100 bonds are also retail, although they may include a small number of institutional trades. We also observe that 144A bonds (which have no retail trading) have extremely few trades less than 100 bonds. 7

9 consist of 4,595 trades. Interestingly, for large (institutional) sized trades, selling exceeds buying for the first 3 days, after which buys and sells are more similar. Retail activity on the other hand consists largely of customer buys, and increases over the first several days of trading. This behavior likely reflects the practice by dealers of acquiring bonds from institutional investors or in the interdealer market, and in turn distributing those bonds to retail investors. Table 4 examines customer trades for the sample bonds. Two-thirds of the sample (2,729 bonds) trades on the first possible day of trading. We report the average and median daily trading volume and number of trades per day for the first 10 trading days following issuance and for longer periods up to 6 months from the issue date. Trading activity increases substantially over the first two days, and then continues to decline (though not as rapidly) over the first six months. Our data also allow us to identify whether the dealer for a given trade is a member of the underwriting syndicate for that bond. Members of the underwriting syndicate are clearly important to secondary market trading, but do not dominate trading as strongly as has been documented for equity IPOs. 12 Based on volume, the market share of trading by underwriters falls from 81.3% after day 1 to 54.5% by day 10, and remains just under 50% for the six months after issuance. Based on the number of trades, the market share of underwriters is smaller, dropping from 52% on the first day to 33% or lower after three months since issuance. This drop likely reflects the entry of non-underwriter dealers trading predominantly with smaller retail investors. The descriptive facts appearing from Tables 3 and 4 are important to our subsequent analysis in several respects. We focus on customer buys for two reasons. First, trading by retail 12 Ellis, Michaely, and O Hara (2002) report unaffiliated market makers have approximately a 30% share of trading volume throughout the first 60 days of trading. 8

10 investors is dominated by customer purchases, and increases substantially by day 3 of trading. Second, focusing on customer buys, our measures are not impacted by variation in bid-ask spreads either across types of trades or across time. Based on the description from Tables 3 and 4, we also expect that behavior may change over the first days of trading as smaller retail investors enter the market. III. Price dispersion. In this section, we examine price behavior during the first days of trading, and the behavior of price dispersion over time. To provide an example of observed prices, Figure 1 plots transactions prices for all customer trades in four individual bonds. Some striking patters appear from these simple plots: trading prices exceed the offer price; there are marked differences between institutional and retail sized trades; within trade size groups, there is considerable variation of prices within the day; and the variation of prices within the day far exceeds the variation from one day to the next, particularly for trades of 100 bonds or less. Within-day price dispersion is therefore an important aspect of newly-issued bonds which appears to vary based on trade size. To investigate this further, we measure price dispersion using only customer buy transactions, and separately for large (> 100 bonds) and small (<= 100 bonds) trades. For each dealer trading in a given bond on a given day, we measure price dispersion as the daily difference between the high and low prices for that dealer. Thus, our measure shows the range of prices that customers pay for the same bond on the same day from the same dealer. Tables 5a and 5b summarize the incidence of price dispersion by trade size group, credit rating, and time period. We also plot in Figure 2 our dispersion measure by the quarter of 9

11 issuance. We pool all observations for the first 10 days of trading. Ideally, our measure of dispersion should reflect only dealer behavior, and not price differences due to a change in the value of the bond during the day. For all reported results, we remove observations on days when the Merrill Lynch 10 year corporate bond index return exceeds ± 0.75%, reducing the likelihood of price dispersion due to bond market movements within the day, and we winsorize to remove outliers. In Appendix Table 5, we report results for the subsample of bonds where a CDS quote is available (from Markit) for that issuer, and remove observations where there is any change in the issuer s CDS quote from the previous day this has a surprisingly small effect on our measures of price dispersion. We also control for other factors that might increase the likelihood that bond values change, for example, by requiring that trades be within the same hour (not reported); this again has little impact on the magnitude or interpretation of our results. Therefore, observed intraday price dispersion is not a result of underlying market movements or a change in the issuer s credit. 13 For the highest quality bonds rated A or better, for the full time period, the mean price dispersion is 22 basis points (BP) for larger trades (Table 5a) and 46 BP for smaller trades (Table 5b). However, the dispersion exceeds 50 BP for 11.5% of the observations for large trades and 28.1% of observations for smaller trades; for smaller trades, the dispersion is greater than 100BP for 16.8% of observations. Thus, even for institutional investors, the magnitude of price dispersion is economically large; price dispersion is of similar magnitude to researchers estimates for total round trip trading costs on higher rated corporate bonds. 14 For the larger 13 The magnitude of price dispersion also does not appear to be due to difference in pricing across trade sizes within our trade size groups. For example, calculating price dispersion for bonds rated A & better using only trades between 300 and 500 bonds, mean dispersion over the full sample period is 19 BP, similar to the mean for all large sized trades in Table 5a; for trades between 10 and 14 bonds, mean dispersion is 45 BP, similar to Table 5b. 14 See, for example, Edwards, Harris, and Piwowar (2007); Bessembinder, Maxwell, and Venkataraman (2007); Goldstein, Hotchkiss, and Sirri (2007). 10

12 trades, 50.7% of these observations are from dealers that are part of the underwriting syndicate. A smaller proportion of observations for small trades is attributable to dealers who are part of the underwriting syndicate. For lower rated bonds, the magnitude of price dispersion is similar. Panel B shows that the mean dispersion for larger trades on BBB bonds is 22 BP, and again 11.3% of observations have dispersion greater than 50 BP; for smaller trades, the mean is 51 BP but 31.6% have dispersion greater than 50 BP and 18.4% have dispersion greater than 100 BP. For large trades in non-investment grade bonds, the mean dispersion is 28 BP. We caution that the number of small sized trades in non-investment grade bonds is much smaller, since most non-investment grade bonds are issued as 144A bonds and thus do not have retail trading. Still, 14.6% of small trades in non-investment grade bonds have price differences greater than 100 BP. It is informative to consider the variation in this behavior over time and as transparency is introduced, potentially reducing dealers market power. We divide the sample into five subperiods, the first four corresponding to changes in transparency regimes and the fifth starting with the onset of the financial crisis. For example, bonds rated A and higher are disseminated in the first period ending March 2003 only if the issue size exceeds $1 billion; therefore, only 45.3% of observations for this group in Table 5a are transparent (disseminated) at the date of issue. As shown in Table 5a, the mean dispersion for bonds rated A and higher during this first period for institutional-sized trades is 28BP. However, starting in the second period, issue sizes greater than $100 million are disseminated, and the mean price dispersion drops to 18BP for large trades. By periods 3 and 4, all non-144a issues are disseminated, and the mean price dispersion drops to about 14BP. With the onset of the crisis (period 5), dispersion increases to 29 BP, similar to the start of our sample period. We observe similar declines for smaller trades 11

13 (Table 5b) as well as for both large and small trades in the other rating groups, though small trades in high yield bonds are limited as noted above. Overall, we find large decreases in price dispersion over time, until the onset of the financial crisis, when price dispersion increases back to earlier levels. This behavior is also apparent from the plots in Figure 2. In Table 6, we report multivariate regressions to consider the impact of time periods and transparency regime on price dispersion. The dependent variable is observations of price dispersion, and we pool observations for the first 10 days of trading. Note that these regressions explain the magnitude, but not the incidence, of price dispersion. We use separate regressions to control for the credit rating at issuance and trade size, as these are systematically related to the time periods for dissemination. We also control for the overall level of trading activity for the bond (number of trades in first month), overall market volatility (VIX), the information environment (issuer has publicly traded stock and issuer has CDS quotes), and 144A status (indicator variable non-144a). Standard errors (in parentheses) are clustered by issuer and trading day. Of primary interest are the time period dummies, and the interactions of these dummies with an indicator for trades which are disseminated. Note that we include the interactions only for time periods where there is some variation in whether bonds of that type are disseminated. As discussed in Green s 2007 Presidential Address, both the availability of information and investors access to that information are important. For retail investors, although information was available for larger and higher quality bonds from the start of TRACE, few retail brokers subscribed to this information, and many investors were likely unaware of its availability. Even for institutional investors, the number of users with immediate access to trading data from 12

14 TRACE has increased substantially over time. 15 Thus, even if trade data were available under transparency early on in TRACE, it is likely that some investors were better informed than others, even among institutions. The negative and significant coefficients for the time period dummies are broadly consistent with the description in Table 5, that dispersion falls relative to period one until the onset of the financial crisis, and the effect is more pronounced for smaller sized trades. Understanding the is impact of transparency is complicated by the fact that whether a transaction is disseminated depends both on the time period and bond characteristics. For example, for bonds rated A and above, by periods four and five, the only bonds not disseminated are 144A bonds (so a dummy for dissemination in those periods is equivalent to a dummy indicating non- 144A). 16 Therefore, while Table 6 shows that dispersion appears to fall over time until the start of the financial crisis, the impact of dissemination itself is less clear. The final variable included in the regressions indicates whether the observation of dispersion is from a dealer who is a member of the underwriting syndicate. The coefficient is consistently positive across rating categories and trade sizes. This demonstrates that dealers which are members of the syndicate contribute significantly to the magnitude of observed price dispersion. 15 Based on information provided by FINRA, the number of institutional subscribers to undelayed TRACE data increased almost linearly from July 2002 to approximately 12,000 in the first quarter of Retail brokers subscribing to TRACE information were negligible at the start of TRACE. However, due to a change in pricing in mid 2006, the number of retail brokers subscribing increased to approximately 12,000 in 2006 and 23,000 in Since the July 2002 start of TRACE, however, historical price information has been available on a delayed basis through the FINRA s web site. 16 In Appendix Table 6, we test for larger trades whether this is likely attributable to 144A status by examining the impact of non-144a using only Period 1 for A-rated bonds and only Periods 1 and 2 for other bonds i.e. no bonds in these subgroups are subject to dissemination. For bonds rated A and above, 144A status is not related to dispersion. For lower rated bonds, non-144a bonds have significantly lower dispersion. These results appear consistent with the negative coefficient for the non-144a variable in Table 6. 13

15 IV. Underpricing. Previous literature has documented either no or small underpricing for corporate bonds. Cai, Helwege and Warga (2006) examine bond trades by insurance companies and find underpricing for both IPO and seasoned bond offerings, but it is significant (though small) only for speculative grade bonds. 17 For the municipal bond market, Green, Hollifield and Schurhoff (2007b) show an increase in price relative to the offering price which occurs slowly over the first few days of trading. In contrast to the corporate bond market, the behavior observed for municipals is almost entirely due to price dispersion in trades by smaller retail investors. Consistent with the literature describing price behavior for equity issues, we measure underpricing as the percentage difference between the observed customer buy price and the offering price. However, observed underpricing may be attributed both to dealer s ability to discriminate among investors (leading to the price dispersion documented in the previous section) as well as the underwriters ex-ante pricing decision. Rather than using the closing price on the first day of trade, we measure underpricing each day for the first 10 days from issuance. We include only customer buy transactions in our calculations to eliminate the effects of the bidask spread, as these spreads are substantially larger than documented for equities and increase with trade size. We also calculate underpricing separately using small and large trades. Due to the confounding effects of price dispersion on underpricing measures, we report underpricing as the percentage spread of customer buy prices over the offer price using two different measures: first, using the volume weighted average daily customer buy price relative to the offer price, and second, using the daily low customer buy price relative to the offer price. Using the daily low price reduces, though does not eliminate, observed underpricing due solely 17 Other studies examining underpricing for bonds include Datta, Iskandar-Datta, and Patel (1997) who find overpricing for some bonds, Helwege and Kleinman (1998), and Wasserfallen and Wydler (1988). Ours is the only study to use comprehensive transactions data for new issues in the corporate bond market. 14

16 to dealers market power in the secondary market, i.e. the dispersion in prices due to market makers ability to charge varying prices to customers for the same bond at the same time. Regardless of the price used, it is clear from Table 7 that significant, positive, underpricing occurs for corporate bonds. 18 Panel A shows the daily underpricing pooled for the first ten days since issuance; all reported mean and median spreads over the offer price are positive and significantly different from zero for each rating group. This is true even when the impact of price dispersion is reduced using the daily low price in the calculation. Underpricing increases as rating falls, and large, institutional size trades have lower underpricing than smaller, retail trades. Panel B shows the underpricing by day since issuance, showing that underpricing increases and becomes more significant by day 3 of trading. 19 This is also apparent from the plots in Figure 3; for investment grade bonds, underpricing is negligible until day 3, and is substantially greater for non-investment grade bonds. The increases in underpricing are more dramatic for smaller, retail trades than for larger, institutional trades, perhaps related to the findings in Table 3 that retail trading increases over time. At first glance, the percentage underpricing appears small relative to what has been shown for equity markets. However, the dollar magnitude is large given the size of the bond offerings. At a mean offering size of $515 million, the average underpricing for a BBB bond of 0.44% by day 3 is equal to almost $2.3 million money left on the table ; for high yield offerings the average underpricing of 1.05% is more than twice as large. Debt offerings are also a 18 We also show significant underpricing when we restrict the sample to days where there is no change in the issuer s CDS quote from the prior day (Appendix Table 7). 19 Results are not market adjusted, which potentially adds noise to our measure since we control for market movements by removing all observations subsequent to a ±.75% or greater in the Merrill Lynch 10 year corporate bond index return. The magnitude of our results is also consistent with anecdotal evidence based on interviews with a number of dealers providing comments related to the implementation of TRACE dissemination. These dealers typically described a successful offering as one where the price rise in initial trading was approximately 0.125% for investment grade issues and 0.25% for high yield issues. 15

17 relatively frequent event for these issuers in comparison to public equity offerings. The percentage spreads are positive and significant both for first time public bond issuers as well as seasoned offerings (not reported for brevity). The observed underpricing may be due both to market power of dealers in after-market trading and/or underwriters ex-ante pricing decision. To reduce the effect of the former, the last group reported in Table 7 shows underpricing for the subsample of bonds where dealers market power is most likely to have been reduced investment grade non-144a bonds issued in a transparent market, a significant time subsequent to the start of TRACE (January 2006) but prior to the financial crisis. As above, underpricing is smaller but positive and significant. Based on simple univariate comparisons, however, the magnitude may have been reduced under transparency. We examine the behavior of underpricing over time using multivariate regressions reported in Tables 8 and 9. The dependent variable is the percentage spread between the daily low customer buy price and the offering price, pooling observations over the first 10 days of trading. We report regressions using the daily low price since this lessens the impact of price dispersion. We again report results separately using calculations based on trades > 100 bonds (institutional trades) and trades <= 100 bonds (largely retail trades). While we do not aim to test competing theories of underpricing as in other literature, we still include controls for several other variables suggested by prior work to be related to underpricing. We control for the number of trades in the first month, and find weak evidence that underpricing is positively related to after-market liquidity (contrary to the predictions of Ellul and Pagano (2006)). We also control for whether the firm has publicly traded stock, as firms with private equity have less information available and less analyst following. This 16

18 variable is negative for the highest and lowest rated bonds, though for BBB bonds we observe a positive coefficient. 20 We also control for issue size, which is highly correlated with issuer size, and again find that the results vary by rating category. The coefficients for the time period dummies in Table 8 show that underpricing falls fairly consistently relative to the earliest TRACE time period, across rating groups and trade sizes. This finding holds even as we control for the dissemination regime (albeit related to bond characteristics). Table 9 reports similar regressions, except that we consider individual transactions rather than average daily low bond price (see also Appendix Table 9 for observations where there is no change from the prior day s CDS quote). 21 The dependent variable is the percentage spread between an observed customer buy price and the offer price. Standard errors are clustered by issuer and trading day. In addition to the control variables in the previous regressions, we also include the log of trade size. Larger trades generally appear closer to the offering price. The time period dummies again indicate underpricing is lower relative to the start of TRACE, except for small trades in non-investment grade bonds; the difference from the previous table for smaller trades is likely due to the fact that trades in these bonds is where much price dispersion is observed. Of key interest in these regressions is the variable indicating whether the dealer for that trade is a member of the underwriting syndicate. Recall from the regressions in Table 6 that underwriter trades are associated with higher price dispersion. If a reduction in price dispersion 20 Only 65% of high yield bonds are issued by firms with publicly traded equity, compared to 94.8% for investment grade bonds. 21 These regressions are closer in spirit to those reported by Green, Hollifield and Schurhoff (2007b). Unlike their results, we do not estimate a mixture model; instead we report regressions separately by trade size (greater or less than 100 bonds) and the day of trade. Green, Hollifield and Schurhoff (2007b) show that size and day are the most important determinants of whether an investor is likely to be informed. 17

19 over time is associated with greater underpricing, issuers will not benefit. For BBB rated bonds, underwriter trades are farther above the offering price, but the magnitude is not great enough to offset the declines in underpricing. For the other rating categories, the coefficient for underwriter trades is negative and significant, indicating trades closer to the offering price. For smaller trades, although the coefficient is positive and significant for investment grade bonds, the magnitude is again small relative to the time period dummies. If dealer market power and/or ex-ante underpricing are reduced over time, the question remains as to whether these changes translate into gains to the issuing company, or are largely a reduction in dealer profits. As argued by Green (2007), a reduction in dealers ability to discriminate among informed and uninformed investors will not necessarily benefit issuers. Combined with Table 6, our results suggest that issuers likely benefit from a decline in underpricing over time since the introduction of TRACE, particularly since much of the observed behavior is related to trades by members of the underwriting syndicate. V. Price behavior and dealer inventory. A unique aspect of our dataset is that it identifies buy and sell transactions by dealer, allowing us to calculate for each day the cumulative inventory position of a given dealer. In this section, we examine how dealer inventory is related to the price behavior of the issue. Dealers might face inventory risk in the event the issue were not received favorably or market conditions were not as expected. Underwriters might therefore increase underpricing to offset this risk. We therefore consider the effect on dealer inventory when issuers perform poorly, i.e. the price trades below the offering price. 18

20 Price behavior in the after-market may impact observed dealer inventory in two ways. First, although there are no explicit price stabilization requirements in this market, dealers may accumulate inventory after the offering by repurchasing bonds placed with investors which have subsequently declined in price. Second, unlike equities, underwriters may continue to hold a portion of the issue after the initial offering; while primary market trades are not reported through TRACE, these subsequent trades may be reported through TRACE as dealer sales to customers. Thus, we may observe large negative long term inventory positions if dealers have retained and later sold a significant fraction of the offering. Table 10 reports dealer inventory positions as a percentage of the offering. For each bond, inventory holdings are calculated for individual dealers, and then summed for all dealers of a given type (underwriter or non-underwriter). For each of the first ten days following issuance, we report inventory based on whether the bond trades at a price greater than or equal to (less than) the offer price as of that day. The trading price is calculated as the average of prices for customer buy transactions of over 100 bonds; if the bond does not trade on a given day, we use the last previously reported price (or missing if there has been no trade since the issue date). We do not divide our sample by market adjusted returns, since dealers potentially face inventory risk in the event the market as a whole moves adversely at the time of the offering. The results in Table 10 show that dealer inventory positions are typically not large. Even when returns are poor, inventory for underwriters reaches a mean of only 2.17% of the issue amount. Median non-underwriter inventory remains near zero. Comparing inventory of underwriters based on whether the bond trades above or below the offer price, mean (median) inventory are in fact higher when returns are negative, but while the differences are strongly 19

21 significant by day 10 they are not economically large. For example, mean inventory for negative return observations exceeds that for positive return cases by 0.84%. Still, larger inventory holdings may only occur in the case of more extreme negative returns. Therefore, Panel B of Table 10 shows inventory of underwriters for the observations where the price has fallen at least $1 or $2 below the offering price. This demonstrates the magnitude of the increase in mean and median inventory at the extremes for our sample. At the 90 th percentile, underwriters hold inventory of around 10% (price falls at least $1) and 12% (price falls at least $2) of the issue. Lastly, we consider whether the more extreme observations coincide with the onset of the financial crisis, defined as March 2007 for our sample. It is interesting that the mean and median returns are not significantly different when we compare bonds issued before and after the onset of the crisis, though the proportion of bonds trading below the offer price is somewhat higher. 22 The incidence of more extreme negative returns increases somewhat for the latter period. Precrisis, 9.7% of issues have fallen by day 10 to at least $1 below the offering price; this compares to 11.6% post-crisis. Table 10C shows inventory holdings of underwriters separately for the preand post-crisis periods for cases of negative returns. Mean and median inventory increase in the crisis period, but not by an economically large amount. There are two possible interpretations for our results. The first is that dealers do not face significant inventory risk, even under less favorable market conditions. The second possible interpretation is that underwriters sufficiently underprice issues to reduce or even eliminate this risk. The results in the prior sections, however, do not suggest any increase in underpricing over 22 Table 2a shows a decline in the number of new issues starting in the 3 rd quarter of Thus it is possible that some firms which would have experienced poor returns chose not to enter the new issues market during this period. 20

22 time as the market becomes more transparent, and particularly in the period of the financial crisis. VI. Conclusions. This paper provides some of the first evidence on the behavior of dealers trading in newly issued corporate bonds. We find that there is economically and statistically significant underpricing for corporate bond issues, but that the measured underpricing reflects both the underwriters ex-ante pricing decision as well as price dispersion in after-market trading. Large institutions are net sellers of bonds in the initial days of trading, while smaller sized retail customers purchase bonds from non-syndicate member dealers at widely varying prices. We do not find evidence that dealers underprice issues to offset inventory risk when issues trade below the offering price. We uniquely measure price dispersion as the difference in price paid across customer buys from the same dealer for the same bond on the same day. While price dispersion can be strikingly large, it appears that the magnitude and incidence of this behavior declines over time. This behavior may reflect declining dealer market power with the increase usage of information from TRACE over time. However, underpricing has not increased to offset declining market power. Our evidence also shows that non-underwriter dealers contribute significantly to the level of trading activity and to observed price dispersion, particularly for smaller trades several days after the offering. Thus, consistent with Green (2007), potential gains from transparency in the secondary market may not pass through to issuing companies. Based on the declines in price 21

23 dispersion, however, it is clearer that both large and small investors benefit from the availability of post-trade pricing information. 22

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