Financial regulation often has unintended negative consequences. One of the many negative impacts of the Dodd-Frank Act was a sharp drop in the liquidity in the corporate bond market.
This reduction in liquidity is a result of banks being restricted in their ability to use capital to take positions in risky assets (the so-called Volcker Rule). Banks traditionally have served as major providers of liquidity, acting as securities dealers in corporate bonds.
Corporate Bond Concerns
Fang Cai, Song Han, Dan Li and Yi Li, authors of the Federal Reserve’s October 2016 working paper. “Institutional Herding and Its Price Impact: Evidence from the Corporate Bond Market,” examined issues created by two recent trends that have raised concerns about the corporate bond market.
The authors note: “On the one hand, the U.S. corporate bond market has expanded rapidly since the crisis, boosted by significant increases in institutional holdings. On the other hand, over the same time period, dealers have sharply shrunk their balance sheets, which may limit their market-making capacity. As such, a surge in simultaneous buying or selling caused by institutional herding could drive asset prices away from their fundamentals, particularly on the downside, and dealers’ limited market-making capacity would only exacerbate this price distortion. Such a potential negative price impact could spiral downwards and accelerate redemption from end investors, which amplifies financial stability risks.”
Their paper sought to answer two questions: Do institutional investors herd in the fixed-income markets? And if so, does institutional herding destabilize bond prices? These obviously are important questions for investors in the corporate bond market, because herding could lead to forced selling, large market impact costs and destabilizing markets.
Investors in corporate bond markets should at least be aware of this potential. This is especially important for ETF investors, who may have chosen to invest in corporate bond ETFs instead of the individual bonds, because the liquidity in ETFs can be much higher than in the individual bonds themselves—at least until you get a destabilizing event. Then liquidity can rapidly become illusory.
Prior studies on institutional herding have focused on equity markets. The research has found that, in the equity markets, the level of institutional herding is low, and evidence on the price impact of herding is mixed.
In examining the impact of herding in the corporate bond market, the authors hypothesized: “If institutional investors herd based on non-fundamental factors such as reputation concerns, we should generally observe bond prices overshoot temporarily and reverse course in the long run. In contrast, if institutional herding is based on bond fundamentals, their collective trades should contribute to price discovery, and there should not be price reversal afterward.”