Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Are bond market bubbles quiet or loud?

Harrison Hong and David Sraer have a nice paper on quiet bubbles at NBER. They argue that while equity bubbles are very loud (high trading volumes in the bubble stocks), debt market bubbles are very quiet (trading volumes actually decline in bubble bonds). This prediction of their theoretical model is vindicated in the empirical data about bond trading volumes during the 2003-2007 credit boom.

In the theoretical model, the quietness of the bubble is driven by the limited upside in bond prices which makes heterogeneity of beliefs less important. By contrast loud equity bubbles arise from large disagreements about fundamentals coupled with short sale restrictions.

This characterization is both interesting and plausible. But, I think that it ignores the relative importance of the primary market in bonds as compared to equities. The annual issuance of stocks is less than two days’ trading in the secondary market which means that the primary market can be ignored in any discussion of the loudness of an equity bubble. In corporate bonds however, the annual issuance is 82 days of secondary market trading, and this is by no means negligible. (Both these pieces of data are from Dealbreaker). Issuance of bonds is analytically the same as shorting of bonds, and a large primary market also serves to attenuate short sale restrictions in the bond markets.

It appears to me that bond market bubbles are very loud when looked at in terms of a rise in issuance activity. It is perhaps for this reason that most attempts to measure credit market bubbles focus on the growth in the amount of credit outstanding which is entirely a measure of the primary market activity.

A closely related point is that the limited upside in bond prices means that a lot of leverage is required to exploit any divergence of opinion. This too leads to increased issuance of debt (typically short term) which leads to increased fragility of the financial system. This implies that bond market bubbles also pop very loudly.

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