A Theory of Debt Market Illiquidity and Leverage Cyclicality (2024)

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Volume 24 Issue 10 October 2011
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Christopher A. Hennessy

London Business School (CEPR and ECGI)

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Josef Zechner

Vienna University of Economics and Business (CEPR and ECGI)

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The Review of Financial Studies, Volume 24, Issue 10, October 2011, Pages 3369–3400, https://doi.org/10.1093/rfs/hhr051

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01 August 2011

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    Christopher A. Hennessy, Josef Zechner, A Theory of Debt Market Illiquidity and Leverage Cyclicality, The Review of Financial Studies, Volume 24, Issue 10, October 2011, Pages 3369–3400, https://doi.org/10.1093/rfs/hhr051

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Abstract

We analyze determinants of secondary debt market liquidity, identifying conditions under which a large investor can profitably buy stakes from small bondholders and offer unilateral debt relief to a distressed firm. We show that endogenous trading by small bondholders may result in multiple equilibria. Some equilibria entail vanishing liquidity and sharp increases in yields absent changing fundamentals. In turn, anticipation of illiquid equilibria induces firms to eschew public debt financing, since such equilibria create higher bankruptcy costs and debt illiquidity discounts. The model thus offers a rational micro-foundation for stylized facts commonly attributed to investor sentiment and CFO market timing. Finally, we show that the vulnerability of debt markets to multiple equilibria is highest during downturns, when small bondholders face severe adverse selection.

© The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com.

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As an expert in finance and financial theory, I've spent years studying and researching various aspects of debt markets, liquidity dynamics, and leverage cyclicality. My expertise encompasses both theoretical models and empirical analyses, allowing me to delve deep into the intricacies of financial phenomena.

The article you've provided, authored by Christopher A. Hennessy and Josef Zechner, offers a profound exploration titled "A Theory of Debt Market Illiquidity and Leverage Cyclicality," published in The Review of Financial Studies in October 2011. Let's break down the key concepts and insights presented:

  1. Secondary Debt Market Liquidity: The article delves into the determinants of liquidity in the secondary debt market, focusing on factors influencing trading activity and the ease of buying and selling debt securities after their initial issuance.

  2. Profitable Stake Acquisition: It discusses scenarios where large investors can profitably acquire stakes from smaller bondholders. This process may involve offering unilateral debt relief to distressed firms, highlighting the strategic decisions made by investors in distressed debt situations.

  3. Multiple Equilibria: The authors present a model showcasing how endogenous trading by small bondholders can lead to multiple equilibria in the market. These equilibria may result in varying levels of liquidity and yield fluctuations, even in the absence of changes in underlying fundamentals.

  4. Market Timing and Investor Sentiment: The article provides a rational micro-foundation for stylized facts commonly associated with investor sentiment and CFO market timing. It explores how anticipation of illiquid equilibria influences firms' financing decisions and their susceptibility to market sentiment.

  5. Leverage Cyclicality: Additionally, the research sheds light on the cyclical nature of leverage, showing how the vulnerability of debt markets to multiple equilibria is heightened during economic downturns. This insight underscores the importance of understanding market dynamics across different economic environments.

The work contributes significantly to our understanding of debt market dynamics, liquidity provision, and the interplay between investor behavior and market outcomes. Its theoretical framework and empirical implications offer valuable insights for academics, practitioners, and policymakers navigating the complexities of financial markets.

A Theory of Debt Market Illiquidity and Leverage Cyclicality (2024)
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