Print
E-MailStefan J. Huber is an Assistant Professor of Accounting at Rice University, Chongho Kim is an Assistant Professor of Accounting at Seoul National University, and Edward M. Watts is an Assistant Professor of Accounting at the Yale School of Management. This post is based on their article forthcoming in the Journal of Accounting Research. Related research from the Program on Corporate Governance includes Big Three Power, and Why it Matters (discussed on the Forum here) and Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy (discussed on the Forum here) both by Lucian A. Bebchuk and Scott Hirst; and The Agency Problems of Institutional Investors (discussed on the Forum here) by Lucian A. Bebchuk, Alma Cohen, and Scott Hirst.
We study how the arrival of firm-specific information during earnings announcements affects liquidity in over-the-counter (OTC) markets. Extensive research has found a decline in equity market liquidity during earnings announcements due to heightened information asymmetry. However, another friction in many markets (e.g., corporate loans and bonds, nonstandard derivatives, and municipal bonds with OTC structures) is search and bargaining costs, where investors must first search for a counterparty and then bargain over the terms of trade. To understand how earnings announcements shape liquidity in these securities markets, we must understand how these frictions interact jointly during earnings announcements.
To explore these issues, we study the dynamics of liquidity (i.e., transaction prices) around earnings announcements in the U.S. corporate bond market, one of the largest OTC markets. We document significant improvements in bond liquidity around earnings announcements stemming from reductions in investors’ search and bargaining costs. Relative to other periods, investors transacting during earnings announcements pay approximately 6%–7% less in transaction costs (5.52 bps in the average bid-ask spread). Overall, our study highlights the importance of considering frictions besides information asymmetry when evaluating the capital market effects of firm-specific information releases.
Our findings are supported by prior theoretical work on search and bargaining in OTC markets (e.g., Duffie et al., 2005, Lagos and Rocheteau, 2017). In these models, the bargaining power of investors depends on their outside options. As a result, investors’ ability to find counterparties (i.e., their search ability) determines their transaction prices and costs. We show that the information released at earnings announcements can reduce search frictions and improve investors’ bargaining power by both encouraging more counterparties to trade and affecting the connectedness of investors’ trading, improving realized transaction prices. In contrast, analytical studies on equity markets (e.g., Kim and Verrecchia, 1994) posit that information asymmetry increases around information releases and, therefore, increases transaction costs. Our collective evidence is consistent with the former force dominating the latter in OTC markets.
In an event-study design, we show that corporate bond liquidity (based on three common measures in the literature: average bid-ask spread, ask-dealer ratio, and imputed roundtrip costs) improves during earnings announcements. Relative to other periods, investors transacting during earnings announcements realize improvements in transaction costs of approximately 5.52 and 3.56 basis points (bps), as measured by average bid-ask spreads and ask-dealer ratio, respectively. Similarly, for transactions that are largely riskless for dealers (as measured by imputed roundtrip costs), these reductions in costs are approximately 1.29 bps.
Economically, the improvements in transaction costs during earnings announcements are nontrivial. Relative to other periods, investors transacting during earnings announcements save approximately 6%–7% in transaction costs. Because earnings announcements bring heightened trading, these differences entail significant dollar amounts. For instance, we calculate that the total savings of transaction costs over our sample period is approximately $2.4 billion per year.
Next, we explore how these liquidity effects arise related to search and bargaining. First, we present evidence consistent with increased dealer accessibility and reduced search costs for market participants during earnings announcements. We find that bond trading spikes during earnings announcement periods, indicating greater availability of counterparties. Accordingly, we document increased dealer activity during earnings announcements, suggesting that investors obtain liquidity in the same securities through more dealers. We also show that these dealers see lower search costs and improved ability to match buyers and sellers during the earnings announcement period, as evidenced by a higher likelihood of observing offsetting transactions. Both these changes improve the relative bargaining power of investors, leading to better prices.
Second, we document that the participation of institutional investors, who have access to more dealers and thus greater bargaining power, increases during earnings announcements. Although we find that both institutional and retail trading increase during earnings announcements in bond markets, there is a disproportionate increase in institutional trading. As institutional investors have better search and bargaining abilities, this leads to better average transaction prices.
We emphasize the liquidity improvements that we document are ultimately a net effect of multiple frictions. In particular, there are significant amounts of informed trading in bond markets around earnings announcements. Therefore, the resulting increases in information asymmetry may offset much of the reduction in search and bargaining frictions or even subsume it. As such, it is critical to consider the interplay between the two forces to holistically depict the liquidity dynamics around earnings announcements.
Using matched pairs of equity and bond securities from the same issuing firm, we show that, although executed transaction prices are improving in bond markets, they deteriorate in equity markets during earnings announcements. These contrasting changes in liquidity highlight how the dominant economic role of earnings announcements shifts in each market, depending on the relative importance of each friction. We observe a net increase in liquidity in bond markets since search and bargaining dominate there, whereas, in equity markets, we observe a decrease in liquidity, primarily driven by information asymmetry. We further show that this interplay between the two frictions exists not only across equity and bond markets but also within bond markets. Specifically, we show that when information asymmetry about a firm’s cash flow increases with an earnings announcement, as proxied by increased equity bid-ask spreads, this mutes the liquidity improvement of the corresponding bonds.
We further explore these issues by studying the dynamics of liquidity across various investor sizes. Although retail and small institutional investors experience liquidity improvements, we find that the largest institutional transactions experience a slight deterioration around earnings announcements. As these investors are most likely to be informed and their trades place the most capital at risk, we attribute this mainly to adverse selection concerns by market-makers. Collectively, these findings highlight that the liquidity effects we document are a net effect of many forces and suggest that our documented liquidity improvements underestimate the reduction in search and bargaining costs.
In summary, this study documents that earnings announcements improve liquidity in U.S. corporate bond markets, one of the world’s largest OTC markets, through reductions in search and bargaining frictions. We further show that the reductions in search and bargaining costs mask the opposing effect of increased information asymmetry, which dominates equity markets over the same period. Overall, we provide new evidence on important channels through which issuer-specific information (e.g., earnings announcements) impact asset prices and liquidity: search and bargaining.
The complete paper is available for download here.
