Over the past 20 years, the share of outstanding corporate bonds rated BBB, the lowest investment-grade rating, has more than doubled. This has left a large volume of securities on the edge of a cliff, from which they could drop to a high-yield rating and become so-called ‘fallen angels’. Some investors may be forced to sell ‘fallen angels’, for example if their mandate prevents them from holding high-yield bonds. And this selling pressure could push bond prices down, beyond levels consistent with the downgrade news. In this post we explore the impact that sales of ‘fallen angels’ could have on market functioning, finding that they could test the liquidity of the sterling high-yield corporate bond market.
Certain policy actions require a high level of precision to be successful. In a recent paper, we find that using margins on derivative trades as a macroprudential tool would require such precision. Such a policy could force derivative users to hold more liquid assets. This would help them to meet larger margin calls and avoid fire-selling their derivatives, which could affect other market participants by moving prices. We find that perfect calibration of such a policy would completely eliminate this fire-sale externality and achieve the best possible outcome, while simple rules are almost as effective. However, calibration errors in any rule could amplify fire-sales and leave the financial system worse off than if there had been no policy at all.