Permanent trading impacts and bond yields

Abstract

We analyse four years of transaction data for euro-area sovereign bonds traded on the MTS electronic platforms. In order to measure the informational content of trading activity, we estimate the permanent price response to trades. We not only find strong evidence of information asymmetry in sovereign bond markets, but also show the relevance of information asymmetry in explaining the cross-sectional variations of bond yields across a wide range of bond maturities and countries. Our results confirm that trades of more recently issued bonds and longer maturity bonds have a greater permanent effect on prices. We compare the price impact of trades for bonds across different maturity categories and find that trades of French and German bonds have the highest long-term price impact in the short maturity class, whereas trades of German bonds have the highest permanent price impact in the long maturity class. More importantly, we study the cross-section of bond yields and find that after controlling for conventional factors, investors demand higher yields for bonds with larger permanent trading impact. Interestingly, when investors face increased market uncertainty, they require even higher compensation for information asymmetry.

Keywords:

• bond markets
• liquidity
• information asymmetry
• credit risk

JEL Classifications: :

• G12
• G14
• G15
• H81

Acknowledgements

We are particularly grateful to the editors, Mark Salmon and Ingmar Nolte, to an anonymous referee and to Alan Huang for helpful comments and suggestions. Also, we would like to thank participants of the 41st Annual Conference of the Money, Macro and Finance Research Group, at Bradford University, the 2009 conference on Individual Decision Making, High Frequency Econometrics and Limit Order Book Dynamics at Warwick University and the 2010 Eastern Finance Association Annual Meetings in Miami Beach, Florida.

Notes

Dunne, Moore, and Portes (2007) report that the total outstanding amount of the euro-area government bonds is more than 3.9 trillion euro and that their daily secondary market size averages 30 billion euro. The ECB (2004) indicates that hedging bond positions is commonly developed on the basis of government bond yields.

Persaud (2006) estimates that MTS accounts for 71.9% of the electronic trading volume of European cash government bonds.

Several other academic studies use data from the MTS markets (see, for example, Codogno, Favero, and Missale 2003; Beber, Brandt, and Kavajecz 2009; Dunne, Moore, and Portes 2007).

The ECB (2004) indicates that the fixed-rate coupon bonds alone account for 65% of the euro-area government bonds.

These data are available at www.markit.com.

The Chicago Board Options Exchange's VIX, a similar US volatility index, is widely known as the ‘worry gauge’ (see Financial Times, 25 August 2007, p. 5).