Larry Swedroe unpacks research on the impact that short-selling a firm’s stock can have on that company’s bond returns.
The academic literature demonstrates that short-sellers, while often demonized, play an important role in the capital markets. For example, short-sale constraints prevent pessimistic opinions from being fully reflected in stock prices, thereby allowing optimistic investors to drive prices above intrinsic value.
In fact, research has found that short-sellers are able to anticipate the public revelation that a company has misstated its financial statements and can predict negative earnings surprises, analyst downgrades and other negative company news. Additionally, researchers have found that expensive-to-short stocks (where borrowing fees are high) have low subsequent returns.
Findings such as these have led some “passive” money management firms (such as AQR, Bridgeway, and Dimensional Fund Advisors in its long-only funds) to suspend purchases of stocks that are “on special” (that is, where securities lending fees are very high).
Short Selling And Bonds
Stephen Christophe, Michael Ferri, Jim Hsieh and Tao-Hsien Dolly King, authors of the April 2015 paper “Short Selling and Cross-Section of Corporate Bond Returns,” contribute to the literature on short-selling by examining the impact of the short-selling of a company’s stock on that firm’s bonds.
They matched short-selling data with 156 individual bond issues available during their sample period, which ran from September 13, 2000 to July 10, 2001. The authors acknowledge the limitation that, “due to the propriety nature of the data,” their “sample period is relatively short.”
Their paper begins by noting:
The authors then hypothesize that “the greater liquidity of the equity market and the stronger presence of unsophisticated retail investors could induce informed traders to use equity short selling as the primary tool for profiting from negative information about the overall firm because the market’s characteristics allow them to more easily disguise their trades. Moreover, if a negative information shock affects a firm’s fundamentals, which in turn changes its expected cash flows and/or risk, both stock and bond prices should decline. This anticipated reaction is quite intuitive, since both stocks and bonds represent claims on a company’s future cash flows.”
Following is a summary of their findings:
The authors noted that their results were consistent with prior studies finding that short interest increases in the month preceding a bond rating downgrade. They concluded that “the overall results support the proposition that short trades in the equity market exert important valuation consequences in the corporate bond market.”
The bottom line is that short-sellers play a valuable role in keeping market prices efficient. And market efficiency is important because an efficient market allocates capital efficiently. If short sellers were inhibited from expressing their views on valuations, securities prices could become overvalued and excess capital would then be allocated to those firms. The evidence presented in this paper also demonstrates the strong link between the equity risk associated with a firm’s stock and the credit risk associated with the same company’s bonds.
This commentary originally appeared January 9 on ETF.com.
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