Liquidity and Price Impacts of Financial Distress: Evidence from the Market for Defaulted Bonds∗

This paper employs bond transaction data from 2002 and 2011 to investigate the trading activity and price dynamics of defaulted corporate bonds, aiming to shed light on the impact of financial distress on trading liquidity and market frictions. We find that, following default, bonds experience more active trading, wider bid-ask spreads, and a sharp drop in prices followed by price reversals. Furthermore, loss of liquidity and price pressures are more severe for defaults during the 2008-2009 financial crisis than defaults in other periods. We also examine broker-dealers’ role in trading defaulted bonds and show that dealers indeed “lean against the wind” by absorbing selling pressures from customers around bond default. Overall, our results suggest that financial strains at intermediaries may amplify the original shocks to the markets for distressed securities. JEL Classifications: G01, G12, G14, G33