Finance Research Letters xxx (xxxx) xxx

Contents lists available at ScienceDirect

Finance Research Letters

journal homepage: www.elsevier.com/locate/frl

Information sensitivity of corporate bonds: Evidence from the

COVID-19 crisis
Grace E. Arnold a, Meredith E. Rhodes *, b
a
College of Urban & Public Affairs, Portland State University, 1825 SW Broadway #241-G, Portland, OR 97201, USA
b
G. Brint Ryan College of Business, University of North Texas, 1155 Union Circle #305339, Denton, TX 76203, USA

A R T I C L E I N F O A B S T R A C T

JEL classification: We explore the information sensitivity of corporate bonds throughout the COVID-19 crisis by
G01 examining whether there is a differential market response to firms with high operating leverage.
G14 Our results show that investors appear to discriminate based on firm operating leverage, which
E58
estimates the inability to adjust operating inputs quickly. Spreads of high operating leverage firms
Keywords: increase by 70 basis points upon the Fed’s corporate credit facilities announcement, while spreads
COVID-19
from all other firms decreased, indicating concern about potential downgrades. When the facil­
Bond spreads
ities expanded, which made some downgraded firms eligible, spreads declined by 146 basis points
Corporate bonds
Operating leverage for highly leveraged firms.

1. Introduction

An important security characteristic in debt contracts is information sensitivity, which is directly related to an investor’s incentive
to acquire information about the security’s payoff (Dang et al., 2015b; Holmström, 2015). Debt contracts are insensitive to information
when there is a low probability of default. That is, there is little incentive for investors to uncover information when debt contracts are
deep in the money. However, when investors receive unexpected information that increases the uncertainty regarding the distance
between firm value and default boundaries, they seek out information to uncover true values. The risk reassessment stemming from
uncovering information causes bonds to switch from insensitive to sensitive states. While changes in information sensitivity have been
shown to contribute to financial market disruptions (Gorton, 2009; Dang et al., 2015a; 2019), there are few studies documenting the
transition between sensitivity states in corporate bonds (e.g., Brancati and Macchiavelli, 2019).
This paper is one of the first to study corporate bond sensitivity for investment-grade (IG) firms during the COVID-19 crisis. We
focus on IG firms because absent a negative shock, higher ratings imply less uncertainty surrounding firm value relative to default
boundaries, indicating that bonds from these firms should be the least sensitive to information.1 The COVID-19 shock exogenously
increased default risk across firms, which should trigger investors to seek out additional information about firm value.
One piece of potentially important information during this period is operating leverage. Firms with high fixed operating costs may
be more constrained in meeting debt obligations if they lack the flexibility to adjust inputs when revenues decline. Thus, we argue that
operating leverage is an important component of a firm’s ability to navigate sudden and unexpected cash flow changes, and should
contain relevant information about default potential. Investors may use operating leverage to get a clearer picture of firm default risk

* Corresponding author.
E-mail addresses: garnold@pdx.edu (G.E. Arnold), meredith.rhodes@unt.edu (M.E. Rhodes).
1
Kwan (1996) show that IG bonds are largely insensitive to firm information compared to speculative grade bonds.

https://doi.org/10.1016/j.frl.2020.101911
Received 17 September 2020; Received in revised form 6 November 2020; Accepted 29 December 2020
Available online 30 December 2020
1544-6123/© 2020 Elsevier Inc. All rights reserved.

Please cite this article as: Grace E. Arnold, Meredith E. Rhodes, Finance Research Letters, https://doi.org/10.1016/j.frl.2020.101911
G.E. Arnold and M.E. Rhodes Finance Research Letters xxx (xxxx) xxx

in response to the COVID-19 induced uncertainty. We posit that the bond market reacts more negatively to firms with a high degree of
operating leverage (DOL) in response to COVID-19 cash flows shocks. Specifically, we examine whether there is a differential market
reaction to IG firms’ operating leverage as the crisis unfolds.
We also assess the impact of various Federal Reserve (Fed) interventions on bond spreads across ratings and DOL. As the Fed
intervenes in corporate credit markets and provides liquidity, this may, in turn, decrease the need for firms to adjust operating costs to
free up cash flow. Thus, we expect that increased access to capital markets via the Fed may lessen bond sensitivity to operating leverage
as investors’ do not need to seek out that information.
We contribute to the literature on the impact of COVID-19 on firms (e.g., Acharya and Steffen, 2020; Brunnermeier and Krish­
namurthy, 2020) and markets (e.g., Haddad et al., 2020; Kargar et al., 2020; Ramelli and Wagner, 2020) as well as the impact of Fed
intervention (e.g., Haddad et al., 2020; Falato et al., 2020; Flanagan and Purnanandam, 2020). Specifically, Flanagan and Purna­
nandam (2020) show that the Fed purchased informationally-sensitive bonds as measured by both issuer stock return and bond bid-ask
spreads during the COVID-19 crisis. Both Flanagan and Purnanandam (2020) and our study show that Fed intervention was effective in
reducing information sensitivity in bond markets.

2. Data

The sample is constructed from the Trade Reporting and Compliance Engine (TRACE), which contains intraday bond transactions,
provided by the Financial Industry Regulation Authority (FINRA).2 Our sample period is December 31, 2019 through June 30, 2020.
Bonds with missing identifiers and variable rates are eliminated from the sample. The remaining bonds are merged with the CRSP/
Compustat database.3 Firms with missing financial data needed to construct operating leverage measures are deleted. Given the swift
changes brought by the pandemic, we examine daily bond spreads. Consistent with prior bond literature, spreads are calculated as the
daily average yield less the Treasury yield that most closely matches the bond’s remaining years to maturity (e.g., Campbell and
Taksler, 2003; Chen et al., 2007).4 We winsorize spreads at the 0.5% level.5 Following Dick-Nielsen et al. (2012), we exclude bonds
with one month remaining to maturity. Treasury yield data are from the Federal Reserve Bank of St. Louis.
We include bond and firm controls in regressions. Bond characteristics and firm 10-day implied volatility are collected from
Bloomberg. Implied volatility controls for asset volatility, which Merton (1974) shows impacts default probability.6 We also control for
firm financial leverage (Merton, 1974), which is calculated as the ratio of total debt to firm market value using the most recent total
debt quarterly numbers from Compustat as of February 2020. Daily firm value is calculated as shares outstanding multiplied by stock
prices collected from Bloomberg. Table 1 reports the summary statistics for our time-varying controls. These variables increase at the
onset of the pandemic, as expected, and stopped increasing upon Fed intervention.
Our measure of operating leverage, which is inversely related to operating flexibility, is estimated as the elasticity of a firm’s
operating income before depreciation (EBITDA) with respect to its sales using the most recent 16 quarterly observations, spanning
fiscal years 2015–2019.7 Following García-Feijóo and Jorgensen (2010)), we calculate operating leverage using a time-series
regression approach where both EBITDA and sales are detrended before estimation to control for spurious correlations in growth
that would bias operating leverage estimates toward a value of one (O’Brien and Vanderheiden, 1987).
We proceed in two steps. First, we estimate the regressions in Eqs. (1) and (2), where EBITDA and Sales are scaled by total assets.
Some firms have negative EBITDA values, so we use an EBITDA transformation, where if EBITDA<0 then − ln(1 − EBITDA) and if
EBITDA≥0 then ln(1 + EBITDA) (Ljungqvist and Wilhelm, 2005; García-Feijóo and Jorgensen, 2010). We collect the residual series for
both EBITDA and Sales to use in the second step in which we estimate the time-series regression defined in Eq. (3). The degree of
operating leverage (DOL) is β and captures the average sensitivity of a firm’s EBITDA to sales. Using DOL, we classify firms in the top
20% as highly leveraged (or “High DOL”). We use a binary DOL measure to simplify interpretation, but the results hold if we use
continuous DOL.
ln(EBITDAt ) = α + λln(EBITDAt− 1 ) + gebitda t + μt,ebitda (1)

ln(Salest ) = α + λln(Salest− 1 ) + gsales t + μt,sales (2)

μt,ebitda = α + βμt,sales + ϵt (3)

2
We apply the Dick-Nielsen (2009) data filters, which eliminate transactions that reflect data entry errors, such as duplicate, cancelled, or reversal
trades.
3
The TRACE-CRSP linking table provided by WRDS is updated through year-end 2019. Thus, any traded bond issued during 2020 is not included
in our sample, consistent with prior literature that eliminates on-the-run bonds.
4
Corporate bond maturities and Treasury maturities do not match perfectly, so we allow for a ± 6-month window around the Treasury maturity
length. For example, we match corporate bonds with remaining maturities between 4.5 and 5.5 years to the 5-year Treasury.
5
We also winsorize spreads at the 1% level as in Dick-Nielsen et al. (2012) and find quantitatively similar results, which are available upon
request.
6
Yu et al. (2010) provides a detailed description of how Bloomberg calculates implied equity volatility. We elected to use implied volatility rather
than historical because of the economic uncertainty induced by the pandemic.
7
We chose operating income before depreciation because depreciation is a noncash charge and is more appropriate for our setting. Mandelker and
Rhee (1984) and Chen et al. (2011) estimate operating leverage similarly, but use operating income after depreciation.

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G.E. Arnold and M.E. Rhodes Finance Research Letters xxx (xxxx) xxx

Table 1
Summary statistics for time varying variables.
Date : Jan 1st–March 22nd March 23rd–April 8th April 9th–May 11th May 12th–June 30th

(1) (2) (3) (4)

Bond Spread 2.467 6.439 5.297 4.359

(5.466) (9.940) (10.458) (10.024)
Bond Liquidity 0.0028 0.0039 0.0032 0.0028
(0.0077) (0.0098) (0.0074) (0.0061)
Implied Volatility 56.515 96.165 74.361 59.821
(65.396) (59.440) (57.674) (40.183)
Financial Leverage 0.352 0.408 0.418 0.406
(0.238) (0.249) (0.253) (0.247)
N 26795 8770 12112 16085

Data on bond transactions are from TRACE and merged with CRSP/Compustat database. Spreads are calculated for each bond as the daily average
yield less the Treasury yield that most closely matches the bond’s. We winsorize spreads at the 0.5% level. Bonds with one month remaining to
security, missing identifiers, and variable rates are excluded from the sample. The mean for each variable over the specified time period is given. The
standard deviation is reported in parenthesis. ‘N’ is the number of observations.

3. Empirical results

3.1. Graphical representation

We begin our analysis by examining daily changes in information sensitivity using the regression defined in Eq. (4). Bond controls
include maturity, liquidity,8 and other bond characteristics, such as optionality, sinking fund provisions, and convertibility. Our time-
varying firm controls are implied equity volatility and financial leverage. Firm fixed effects capture any time-invariant firm charac­
teristics and day fixed effects capture daily variables that impact all firms and bonds, such as general market movements or interest rate
changes. Standard errors are clustered at the firm-bond maturity level.
( )
Spreadi,j,t = α +Σt βt High DOLj,t × t + βBond Controlsi,j,t
(4)
+βFirm Controlsj,t + λj + λt + ϵi,j,t

We split IG firms into two categories based on rating: AAA-A and BBB. The BBB-rated firms are the most vulnerable to the cash flow
shock because they face “Fallen Angel risk,” which is the risk of being downgraded to speculative grade.9 Figs. 1 and 2 plot βt and the
corresponding 95% confidence interval for AAA-A rated firms and BBB-rated firms, respectively. Each coefficient captures the spread
variation attributed to high DOL on day t for bond i issued by firm j. We highlight several key events related to US Government
declarations and Fed policies, which are represented by vertical dashed lines in the figures and are presented in the following order:

• March 13: US declared a national emergency

• March 23: Fed announced the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF). Under the PMCCF,
the Fed can buy newly issued bonds or bank loans. Under the SMCCF, the Fed can buy existing bonds either individually or through
exchange-traded funds (ETFs).
• April 9: Fed expanded PMCCF and SMCCF, making any firm rated IG on March 22nd eligible under the facilities even if it has
suffered a downgrade, provided the downgrade is not below BB-
• May 12: Fed began buying ETFs holding corporate bonds under the SMCCF
• June 16: Fed began buying individual corporate bonds under the SMCCF

From Fig. 1, we see that for AAA-A firms, there is little variation in bond spreads for high DOL firms compared to other firms,
relative to January 2nd. AAA-A rated firms appear to be perceived as equally safe with respect to their operating leverage throughout
the COVID-19 crisis.
BBB-rated bonds tell a different story, as shown in Fig. 2. Before the US declaration of a national emergency on March 13th, there is
virtually no covariation between spreads and operating leverage. That is, relative to January 2nd, there is no statistical difference
between the spreads of firms with high and low operating leverage. Investors appear to perceive these firms as equal. Bond spreads
begin to trend upward around the time of the emergency declaration, suggesting that investors are trying to discriminate across firms
based on ability to meet debt obligations, given a drastic reduction in expected revenue. However, the standard errors are also

8
Bond liquidity is estimated using the daily average imputed round trip cost (IRC) based on Feldhütter (2012).
9
The proportion of IG debt that are BBB rated has increased in recent years, causing concern among investors. There was approximately $10
trillion in IG debt outstanding in 2019, approximately 47% of US GDP. BBB-rated debt comprised over 50% of this amount (Parker and Harrison,
2019). Given its significant size, a sudden wave of downgrades of IG bonds has economic implications due to the size of the market. The Inter­
national Monetary Fund highlighted the impact BBB-rated debt may have on financial stability if economies experience a contraction (See “Is
Growth at Risk?” October 2017, IMF Global Financial Stability Report).

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G.E. Arnold and M.E. Rhodes Finance Research Letters xxx (xxxx) xxx

Fig. 1. Estimated coefficient on High DOLj,t × t for AAA-A firms. Figure notes: Data on bond transactions are from TRACE and merged with CRSP/
Compustat database. Spreads are calculated for each bond as the daily average yield less the Treasury yield that most closely matches the bond’s. We
winsorize spreads at the 0.5% level. Bonds with one month remaining to security, missing identifiers, and variable rates are excluded from the
sample. All regressions control for day and firm fixed effects. Bond controls include maturity, liquidity, optionality, sinking fund provision, and
convertibility. Implied equity volatility is also included in all regressions. High DOL is a binary variable equal to one if a firm’s DOL is in of the top
20%, and zero otherwise. See Section 2 for more details on the variables. See Eq. (4) for the estimating equation. Spiked lines represent 95%
confidence intervals. Standard errors are clustered at the firm-maturity level.

increasing around this same time.

For BBB-rated firms, there is little reaction in bond spreads upon the initial announcement of the corporate credit facilities. Initially,
only IG firms are eligible, which means firms downgraded to speculative grade would have neither access to the capital markets nor
liquidity support in existing bonds through the Fed. BBB-rated firms with high DOL are at risk of being downgraded because these firms
cannot adjust operating expenses quickly to free up funds for immediate debt obligations. However, bond spreads from high DOL firms
responded favorably to the April 9th announcement to expand these two programs in size and scope. The expansion made companies
with IG ratings as of March 22nd eligible for Fed support, opening up the facilities to some Fallen Angels.10 Fed intervention decreased
the uncertainty of capital market access for Fallen Angels, making operating leverage information less valuable. Thus, information
sensitivity decreased.
The first two announcements were verbal commitments from the Fed. It took seven weeks for the Fed to arrange the technical
details and launch the SMCCF, which officially launched May 12th when it bought corporate bond ETFs. Individual bonds were not
purchased under the SMCCF until June 16th.11 The declining coefficients seen in Fig. 2 after May 12th suggest that once the Fed
transitioned from verbal commitments to bond purchasing, operating leverage information became less valuable to investors again as
all BBB-rated firms were perceived as equal under the new Fed supported credit environment.12

10
IG firms downgraded to speculative grade are referred to as Fallen Angels. Fallen Angels downgraded below the BB- level are not eligible for the
programs.
11
There is anecdotal evidence that investors who bought individual bonds in March and April became increasingly concerned as they waited for
the Fed to officially launch the programs after the March 23rd announcement (Wirz, 2020).
12
One concern with this analysis is that the dependent variable is at the bond-level, while the main independent variable is at the firm level. To
address this concern, we constructed a bond-weighted average spread and reran the analysis; however, we cannot control for bond characteristics in
this setting. The results show increased sensitivity to operating leverage across firm ratings at the key event dates. For the AAA-A firms, this result is
driven by callable bonds. When callable bonds are excluded, all findings are similar to those presented in Figs. 1 and 2.

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G.E. Arnold and M.E. Rhodes Finance Research Letters xxx (xxxx) xxx

Fig. 2. Estimated coefficient on High DOLj,t × t for BBB firms. Figure notes: Data on bond transactions are from TRACE and merged with CRSP/
Compustat database. Spreads are calculated for each bond as the daily average yield less the Treasury yield that most closely matches the bond’s. We
winsorize spreads at the 0.5% level. Bonds with one month remaining to security, missing identifiers, and variable rates are excluded from the
sample. All regressions control for day and firm fixed effects. Bond controls include maturity, liquidity, optionality, sinking fund provision, and
convertibility. Implied equity volatility is also included in all regressions. High DOL is a binary variable equal to one if a firm’s DOL is in of the top
20%, and zero otherwise. See Section 2 for more details on the variables. See Eq. (4) for the estimating equation. Spiked lines represent 95%
confidence intervals. Standard errors are clustered at the firm-maturity level.

3.2. Fed intervention analysis

To understand how spreads react to specific Fed interventions, we exploit the timing of each announcement to capture market
response on March 23rd, April 9th, and May 12th. We estimate Eq. (5) using the five days before and after each announcement. Bond
and firm controls, as described in Section 3.1, are included in all regressions. The variable Fed Intervention is a binary variable equal to
one on and after each specified intervention. Fed Intervention is interacted with our binary variable, High DOL, which is defined in
Section 3.1. Standard errors are clustered as the firm-bond maturity level.
( )
Spreadi,j,t = α +β1 Fed Intervention + β2 Fed Intervention × High DOLj,t
(5)
+βBond Controlsi,j,t + βFirm Controlsj,t + λj + ϵi,j,t

Table 2 reports the estimates for β1 and β2 from Eq. (5). The coefficient β1 describes the impact of the Fed intervention for firms that
do not have high DOL. The coefficient on the interaction term, β2 , tells us whether the mean difference in spreads before and after
intervention is different for high DOL firms compared to all other firms in the rating group. Panel A displays the results for all IG firms,
Panel B is the subset of AAA-A firms, and BBB-rated firms are in Panel C.
Upon the first intervention, IG firms that do not have high DOL experience an average decline in bond spreads of 25 basis points
(bps), while firms with high DOL experience an increase in bond spreads of 70 bps.13 This suggests there is market concern for Fallen
Angel risk that would cause some firms to be ineligible for Fed credit facilities. When the Fed expands eligibility requirements to
include some Fallen Angels on April 9th, all IG bonds experience a decline. The impact is greater for those bonds issued by high DOL
firms, which may benefit the most from the announcement, with a spread decline of 147 bps compared to a decline of 70 bps for all
others. These results imply that investors considered a firm’s operating leverage to identify a potential downgrade, which would make
the firm ineligible per the first announcement.
After categorizing firms based on credit ratings, we see distinct differences across groups. Upon the first Fed announcement for

13
The coefficient on Fed Intervention implies that, relative to no Fed intervention, bond spreads fell by roughly 25 basis points. For high DOL firms
post-intervention, the coefficient implies that bond spreads rose 95 basis points. To find the cumulative effect of Fed intervention for high DOL firms,
we add the two coefficients together, 95 − 25 = 70 basis points.

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G.E. Arnold and M.E. Rhodes Finance Research Letters xxx (xxxx) xxx

Table 2
The impact of Fed intervention and DOL on bond spreads.
Date of intervention: March 23rd April 9th May 12th

(1) (2) (3)

Panel A: All IG Firms

Fed Intervention 0.250*** 0.696*** 0.110***
(0.081) (0.041) (0.018)
High DOL × Fed Intervention 0.949*** 0.766*** 0.079*
(0.309) (0.199) (0.048)
Mean 5.42 4.95 3.37
N 4963 4498 3593
Panel B: AAA-A Firms
Fed Intervention 0.535*** 0.476*** 0.122***
(0.055) (0.029) (0.019)
High DOL × Fed Intervention 0.101 0.118** 0.041
(0.125) (0.056) (0.051)
Mean 3.26 1.69 0.97
N 2391 1831 1400
Panel C: BBB Firms
Fed Intervention 0.010 0.892*** 0.094***
(0.155) (0.062) (0.027)
High DOL × Fed Intervention 1.408*** 0.896*** 0.110*
(0.407) (0.262) (0.063)
Mean 6.48 6.27 4.16
N 2572 2667 2193

Data on bond transactions are from TRACE and merged with CRSP/Compustat database. Spreads are calculated for each bond as the daily
average yield less the Treasury yield that most closely matches the bond’s. We winsorize spreads at the 0.5% level. Bonds with one month
remaining to security, missing identifiers, and variable rates are excluded from the sample. All regressions control for day and firm fixed
effects. Bond controls include maturity, liquidity, optionality, sinking fund provision, and convertibility. Implied equity volatility is also
included in all regressions. High DOL is a binary variable equal to one if a firm’s DOL is in the top 20%, as described in Section 2. “Mean”
reports the average spread for high DOL firms for the five days pre-intervention. “N” is the number of observations from each regression.
Each regression uses observations from 5 days before and after the announcement identified in each column. Standard errors clustered at the
firm and maturity level are reported in parentheses. * 0.10, ** 0.05 and *** 0.01 denote significance levels.

AAA-A firms, bond spreads decline at least 54 bps, and there is no statistical difference in market response based on operating leverage.
However, BBB-rated firms without high DOL have no statistical response to the Fed announcement, while those with high DOL
experienced an increase in bond spreads. This finding implies that the bond market may have anticipated that some firms might be
downgraded, making them ineligible for Fed support.
When eligibility requirements expand to include some Fallen Angels on April 9th, bond spreads for high DOL firms across ratings
experience larger spread declines than all other firms in their respective groups, further indicating market concern for Fallen Angel
risk. For the AAA-A rated group, high DOL firms experience an additional 11.8 bps decline compared to other firms. For BBB-rated
firms, the effect is even larger. Firms without high DOL experience a decline of 89 bps, while firms with high DOL see a total
decline of approximately 178 bps. The results from March 23rd and April 9th support the hypothesis that high DOL firms are the most
vulnerable to a negative shock and that operating leverage was an important piece of information throughout the health crisis.
On May 12th, the Fed transitioned from verbal commitment to bond buying. Here we see that spreads decline for both AAA-A and
BBB-rated firms. We find no statistical difference in bond market response for AAA-A rated firms with high DOL. However, we do see a
marginally significant additional decline in spreads for BBB-rated firms with high DOL. Overall, these findings imply that Fed inter­
vention was effective in reducing the informational importance of operating leverage, thereby reducing bond market sensitivity to
operating leverage.

4. Conclusion

Although limited to the corporate bond markets for IG firms, our results improve our understanding of market disruptions during
the health crisis by focusing on information sensitivity. We draw upon theories of informational explanations of crises to highlight one
aspect of the COVID-19 impact on financial markets. We find evidence that one important piece of information that investors used to
determine a firm’s ability to withstand the health crisis is operating leverage. Increased information sensitivity is concentrated pri­
marily in bonds of BBB-rated firms with high operating leverage, which face the greatest risk of being downgraded to speculative
grade. Further, our results provide evidence that the Fed’s intervention was effective in supporting financial market function by
reducing information sensitivity in corporate bond markets.

Declaration of Competing Interest

None.

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G.E. Arnold and M.E. Rhodes Finance Research Letters xxx (xxxx) xxx

This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

CRediT authorship contribution statement

Grace E. Arnold: Conceptualization, Data curation, Formal analysis, Funding acquisition, Investigation, Methodology, Project
administration, Resources, Software, Supervision, Validation, Visualization, Writing - original draft, Writing - review & editing.
Meredith E. Rhodes: Conceptualization, Data curation, Formal analysis, Funding acquisition, Investigation, Methodology, Project
administration, Resources, Software, Supervision, Validation, Visualization, Writing - original draft, Writing - review & editing.

Acknowledgments

We thank Blair Marquardt, Takeshi Nishikawa, and an anonymous referee for helpful comments and feedback.

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