The Dark Side of Liquid Bonds in Fire Sales
Abstract
We investigate which bonds investors should sell when they need to raise cash quickly. Our model shows that the intuitive strategy of selling the most liquid bonds can backfire. In over-the-counter markets, liquid bonds trade fastest, but when many investors simultaneously sell the same liquid, widely held bonds while buying capital is scarce, their prices fall the most. Individual investors do not fully internalize how their sales amplify the liquidation losses of others, making the outcome privately optimal but collectively inefficient. We test these predictions using property and casualty insurers around major natural catastrophes and find that insurers sell liquid bonds first, only partially avoid crowded bonds, and that liquid bonds experience the largest price declines during fire sales. The overlap in liquid holdings thus emerges as a key source of systemic risk that should receive greater weight in regulation and risk measurement.
This paper was accepted by Lukas Schmid, finance.
Funding: C. Scheuch is grateful for financial support from the Austrian Science Fund (FWF) [Grant DOC 23-G16].
Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2023.03670.
