Bond liquidity, risk taking and corporate innovation

Purpose The purpose of this paper is to investigate how market liquidity condition of corporate bonds can affect firm investment policy, specifically its risk taking, via the disciplinary function of trading. Design/methodology/approach The paper uses fixed-effects OLS and Poisson regression for the baseline specifications. It also employs the introduction of TRACE in 2002 as an exogenous shock to bond trading infrastructure in a difference-to-difference framework to address endogeneity concerns and establish causality. Findings The paper documents a positive relationship between bond illiquidity and firms’ risk taking, specifically a one standard deviation increase in Amihud illiquidity measure is associated with nearly 20 percent increase in exploratory investments compared to CAPEX. The shift in risk taking in turn increases firms’ innovation output to some extent. Research limitations/implications The findings have important implications on firm’s risk taking and growth. The paper identifies a new channel through which firm’s choice of risk can be influenced, namely, bondholder disciplining. The study also has implications about externalities of trading beyond liquidity cost for regulators in designing market microstructure. Originality/value This is the first to study the disciplinary role of bond trading. Conventional wisdom holds that bondholders are passive creditors who do not engage in costly monitoring such as banks. The findings in this paper imply that this may not be the case.