[We analyze determinants of secondary debt market liquidity, identifying conditions under which a large investor can profitably buy stakes from small bondholders and offer unilateral debt relief to a distressed firm. We show that endogenous trading by small bondholders may result in multiple equilibria. Some equilibria entail vanishing liquidity and sharp increases in yields absent changing fundamentals. In turn, anticipation of illiquid equilibria induces firms to eschew public debt financing, since such equilibria create higher bankruptcy costs and debt illiquidity discounts. The model thus offers a rational micro-foundation for stylized facts commonly attributed to investor sentiment and CFO market timing. Finally, we show that the vulnerability of debt markets to multiple equilibria is highest during downturns, when small bondholders face severe adverse selection.]

We are delighted to announce that the winner of the 2011 Spängler IQAM Best Paper Prize is: “Operating Leverage” by Robert Novy-Marx, The two runners-up for the award are: “Inside Debt” by Alex Edmans and Qi Liu and “Fear of the Unknown: Familiarity and Economic Decisions” by Henry Cao, Bing Han, David Hirshleifer, and Harold Zhang, The awards were presented at the 2011 annual meeting of the European Finance Association in Stockholm on August 19. We are grateful to Spängler IQAM Invest for sponsoring this award.

We analyze determinants of secondary debt market liquidity, identifying conditions under which a large investor can profitably buy stakes from small bondholders and offer unilateral debt relief to a distressed firm. We show that endogenous trading by small bondholders may result in multiple equilibria. Some equilibria entail vanishing liquidity and sharp increases in yields absent changing fundamentals. In turn, anticipation of illiquid equilibria induces firms to eschew public debt financing, since such equilibria create higher bankruptcy costs and debt illiquidity discounts. The model thus offers a rational micro-foundation for stylized facts commonly attributed to investor sentiment and CFO market timing. Finally, we show that the vulnerability of debt markets to multiple equilibria is highest during downturns, when small bondholders face severe adverse selection. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

ABSTRACT Intermediaries such as financial advisers serve as an interface between portfolio managers and investors. A large fraction of their compensation is often provided through kickbacks from the portfolio manager. We provide an explanation for the widespread use of intermediaries and kickbacks. Depending on the degree of investor sophistication, kickbacks are used either for price discrimination or aggressive marketing. We explore the effects of these arrangements on fund size, flows, performance, and investor welfare. Kickbacks allow higher management fees to be charged, thereby lowering net returns. Competition among active portfolio managers reduces kickbacks and increases the independence of advisory services.