The Cost of Liquidity Provision in Bond Markets During Periods of Market Stress

The SEC implemented a short sale ban on financial stocks in September 2008 that lasted 20 days. This action made it difficult for convertible bond hedge funds to maintain arbitrage strategies, prompting many of them to sell their positions creating an unintentional liquidity shock in the convertible bond market. By treating this as a quasi-natural experiment, we are able to estimate the costs of obtaining liquidity when financial markets are under significant stress. Surprisingly, we find that bid-ask spreads for convertible debt decrease relative to straight debt, which we attribute to the lack of anonymity in bond markets. Our evidence is consistent with the conjecture that reductions in adverse selection costs are larger in magnitude than possible increases in dealer search costs.