Liquidity risk of corporate bond returns: conditional approach

Abstract

We document capital misallocation in the U.S. investment-grade (IG) corporate bond market, driven by quantitative easing (QE). Prospective fallen angels — risky firms just above the IG cutoff — enjoyed subsidized bond financing in 2009–19. This effect is driven by Fed purchases of securities inducing long-duration IG-focused investors to rebalance their portfolios towards higher-yielding IG bonds. The benefiting firms (i) exploited the sluggish downward adjustment of credit ratings after M&A to finance risky acquisitions with bond issuances, and (ii) increased market share affecting competitors’ employment and investment, but (iii) suffered severe downgrades at the onset of the pandemic.