The Dark Side of Liquid Bonds in Fire Sales

We investigate which bonds institutional investors sell in fire-sales. We find that these are mostly bonds that were trading in liquid markets before the fire-sale, and that they are sold by other institutions as well. Somewhat surprisingly, the price impacts in these markets are higher than in bonds that were trading in less liquid markets before the fire-sale, but are also liquidated during fire-sales. It appears as if liquid bonds in fire-sales exhibit larger price impacts than less-liquid bonds. We argue this is because institutions fail to fully account for the effect of selling common bonds on other market participants. Controlling for commonality of bonds, we find that in fire-sales liquid bonds have smaller price impacts. This result matters for the measurement of systemic risk: the commonality of liquid bonds exacerbates fire-sales losses, as they are sold more in fire-sales. So measures of portfolio similarity should over-weight liquid bonds overlap, not under-weight it.