WHITE PAPER Corporate and Municipal Bond Trading Costs During the Financial Crisis 1 Peter Ciampi, Interactive Data Corporation Eric Zitzewitz, Dartmouth College August 2010 Abstract We measure trading costs for large and small trades in corporate and municipal bonds using data from the TRACE and MSRB datasets, and for corporate bonds exploiting the recent addition of a direction of trade variable to TRACE. We find significantly larger trading costs for smaller trades, lower quality bonds, longer duration bonds, and during the “crisis” period of late 2008 and early 2009. We find higher spreads than reported by other studies for earlier time periods. Introduction Whereas the study of the execution quality of equity trades has been facilitated by datasets such as the New York Stock Exchange’s Trades and Quotes data, no comparable dataset exists for corporate bonds, which trade largely in a dealer market rather than on an exchange. Many early studies of bond trading used data collected by the National Association of Insurance Commissioners (NAIC), which covered bond trades placed by member insurance companies. This data, while useful, reflected the costs incurred by institutional customers who typically traded large orders. The development of the FINRA Trade Reporting and Compliance Engine (TRACE) and the Municipal Securities Rulemaking Board (MSRB) datasets for corporate and municipal bonds, respectively, allow one to better study the trading costs to all market participants. The utility of TRACE has also been recently enhanced with the addition of a “reporting party side” variable that discloses whether a trade involved a dealer that was purchasing from a non-dealer client (B), selling to a non-dealer client (S), or trading with another dealer (D). In this note, we use these newer public datasets to estimate trading costs during the financial crisis period, with a particular emphasis on the differing costs incurred in connection with large and small trades. We find spreads that are significantly larger than those estimated in past work, particularly during the last two months of 2008 and the first half of 2009. During our sample period, the retail-sized (defined as under $100,000 in face value) corporate bond trades involved median two-way trading costs of 155 basis points (bp), while institutionally-sized trades (greater than or equal to $500,000 in face value) were 28 bp. For municipal bonds, retail-sized trades involved median two-way costs of 251 bp and institutionally-sized trades were 61 bp. Mean spreads are 1.1-1.5 times larger than median spreads: 207 and 38 bp for corporate bonds and 272 and 92 bp for municipal bonds. Larger trading costs for smaller trades have been found in the past for bonds (Hong and Warga, 2000; Schultz, 2001; Chakravarty and Sarkar, 2003; Harris and Piwowar, 2006) but not equities (e.g., Lin, Sanger, and Booth, 1995). 1 This paper is a revised version of “Corporate Bond Trading Costs During the Financial Crisis,” which we circulated and presented at the Regional Bond Dealers Association Fixed Income roundtable in June 2010. We thank participants at that meeting for helpful comments. The major change is to add data on municipal bond trading costs. © 2010 Interactive Data Pricing and Reference Data, Inc. 1