Structural Changes in Corporate Bond Underpricing

Over-the-counter (OTC) markets are characterized by the fact that trading between market-participants takes place on a bilateral basis. Hence, there is no central platform through which orders are submitted, only intermediaries that are typically large investment banks. This implies that trading relationships between intermediaries and investors are an important determinant of prices. It seems rather intuitive that these relationships might be particularly important in times in which intermediaries are constrained in their capacity to absorb large transactions.

The US corporate bond market (a $ 8.2 trillion market in 2015) represents an ideal laboratory to examine how prices are determined in an OTC market, and to what extent external changes in the capacity of dealers, e.g. through regulation, affect the incentive structure of dealers. The reason is that after the financial crisis, many new regulatory rules were implemented, and in particular the Volcker-Rule. These rules should make intermediaries safer and less prone to financial crisis.

However, on the other side, we show that these new regulatory rules come at a cost. The cost is that firms that want to issue securities in the US corporate bond market have to pay more. When a firm wants to issue a corporate bond, it uses an underwriter that helps the firm to place the bonds to investors. These underwriters have a central role because, besides providing placement services to firms, they also act as dealers between investors after bond issuance. But due to the low interest rates, many new firms approach the market and investors increasingly engage in 'reaching for yield', that is, they try to get access to bonds which are not traded but potentially undervalued.
The post-crisis regulation affects, thus, the issuance process of underwriters.

Specifically, in the post-crisis period underwriters have an incentive to place bonds to closely affiliated investors at issuance in order to secure access to the new securities. However, the cost is that these underwriter-affiliated investors want to get better prices, i.e. lower prices, for the service they provide. In total, this increases the issuance costs for firms and might lead to real effects, i.e. firms can only invest less.

Average underpricing – the price differential between the secondary and primary market – has increased from 23 basis points ('bps') in the pre-crisis period to 64 bps after the crisis. Hence, money is left on the table for issuing firms because the secondary market prices are significantly higher compared to the offering prices in the primary market. Furthermore, trading activity of newly issued bonds is up to three times higher in the post-crisis period compared to before, as investors close to the underwriter immediately sell securities bought at a low price. In other words, underwriters give closely related investors access to the most underpriced bonds, and in exchange for that these investors use the underwriter later on in the secondary market to intermediate transactions.

Overall, there might be one important lesson that is generalizable to many situations. That is, in OTC markets, it seems easier to circumvent new regulations, because the structure of the market is too opaque in the first place.