Sovereign Credit Quality and Violations of the Law of One Price
Jacob Boudoukh, Jordan Brooks, Matthew Richardson, Zhikai Xu
Review of Finance, Volume 25, Issue 5, September 2021, Pages 1581–1607, https://doi.org/10.1093/rof/rfab001
Numerous violations of the law of one price for financial assets (i.e., securities with almost identical cash flows trading at different prices) have been documented. There is arguably no better illustration of this phenomenon than that of government bonds, in particular, the higher pricing of the most recently issued bond versus a previously issued counterpart matched by maturity and cash flow. The explanation for this pricing spread, denote the New Issue (NI) spread, is that the new bond commands a convenience yield, being a close substitute for money and more liquid.
This paper offers an additional and novel source for the pricing of sovereign government bonds. In stressful periods, investors “fly” from the weak sovereigns, leading to a tightening, not widening, of the NI-spreads in these sovereigns’ spreads. This flight takes place in the most liquid instruments, pushing down the prices of the most liquid bonds relative to illiquid bonds of the weak sovereigns, leading to tightening NI-spreads.
We study the behavior of the NI-spread across a range of European countries over an extensive time period, 2006 to 2018. We document that, in periods of changing credit spreads, NI-spreads of weakening (strengthening) sovereigns do indeed tighten (widen). This result is surprising because, having the same credit risk, the sovereign bond’s credit should not play a role in relative pricing. Stale pricing does not empirically explain this result. What then are the possible reasons for the behavior of the NI-spread when the credit quality of a sovereign changes?
We look into the possibility that the convenience yield becomes less relevant as credit quality deteriorates as well as other characteristics of newly issued bonds such as specialness and the supply of the bond. While a popular proxy for the convenience yield provides explanatory power for the NI-spread, the results do not point to it being driven by credit quality per se.
Because there is no “easy” arbitrage between newly and previously issued bonds when some market segmentation exists, price pressure can move prices of substitutable assets. We document two key stylized facts supporting a price pressure explanation. First, investors tend to “fly” from sovereign bonds of deteriorating quality. The net flows into and out of sovereign government bonds by institutional investors (as measured by State Street Associates’ dataset on the aggregated activity of institutional investors) are negatively correlated with changes in the credit quality of these bonds (as measured by their current CDS spread relative to a medium-term moving average). Second, our argument requires investors to first transact in their most liquid holdings to minimize price impact when shifting away from decreasing quality assets. The selling (buying) pressure on the low (high) quality sovereigns then leads to temporary price movements in their liquid bonds, which at some later date are reversed. We provide empirical evidence consistent with temporary price pressure impacting the prices of liquid sovereign bonds.