Swedroe: ‘Sell Herding’ In Corporate Bonds

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.

Liquidity Issues

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.”

The Analysis
Cai, Han, Li and Li conducted their analysis separately for three types of institutional investors in this market—mutual funds, insurance companies and pension funds. This helped them better understand the implication of herding, because investor behaviors may differ due to their various regulatory, payout and governance structures.

The authors’ data sample covered the period from the third quarter of 1998 through the third quarter of 2014, and included only dollar-denominated, fixed-coupon corporate bonds issued by U.S. companies. Their sample began the period with assets of $1 trillion and ended with total assets of $2.7 trillion. Note the significant increase in assets at the same time that market liquidity has fallen.

Following is a summary of their findings:

• The level of institutional herding in corporate bonds is substantially higher than what has been documented for equities, about three times greater. This is particularly true among bonds with lower ratings.
• Sell herding is generally stronger than buy herding. And, as more institutions herd, herding increases, escalating the risk of “fire sales.”
• The average bond herding levels of pension funds and mutual funds are each about 10%, significantly greater than levels of about 3% for the respective type of equity funds. This indicates funds in each group are roughly 10% more likely to trade on the same side than one would expect if they made their trading decisions independently.
• Insurance companies, the largest investor group in corporate bonds, have a greater tendency to herd than mutual funds and pension funds, boasting a 13% average herding level.
• The herding level in trading lower-rated bonds—at 12% and 22% for high-yield and unrated bonds, respectively—is notably higher than that for investment-grade bonds (9%).
• Sell herding in corporate bonds is significantly stronger than buy herding. This result is mostly driven by mutual funds, the most active traders and fastest-growing investors in corporate bonds.
• Over time, mutual funds also stand out by exhibiting unique trends, with buy-herding levels declining and sell-herding levels rising.
• Rating changes, bond liquidity and past bond performance are key factors that drive herding by different types of investors.
• Perhaps unsurprisingly, given their regulatory regime, insurance companies more strongly react to rating-change events, particularly downgrades. What’s more, mutual funds and pension funds take advantage of such market frictions to buy bonds when insurance companies are forced to sell.
• All investors herd to buy winning bonds and to sell losing bonds, with the herding behavior of insurance companies most sensitive to bonds’ past performance.

Bad Performance Leads To Selling Herds
Importantly, the authors found that “extremely bad past performances are associated with disproportionally large selling herds, while top-performing bonds do not attract disproportionally large buying herds. Such asymmetry suggests that bonds’ extremely bad past performances may trigger a larger amount of simultaneous sells from institutional investors, a condition that could lead to further price declines and in turn result in more sells and a downward price spiral.”

This finding is consistent with prior research showing that bond mutual funds’ outflows are more sensitive to bad performance than their inflows are to positive performance, suggesting that when bond mutual funds experience outflows due to bad past performance, they are more likely to liquidate the same underperforming bonds at the same time, disrupting markets.

Also of importance is that Cai, Han, Li and Li documented strong persistence in herding, especially on the sell side, showing that bond investors not only herd within a quarter, but that they also herd over adjacent quarters. In other words, trading is driven by the actions of other institutional investors. Again, this is different than what is seen in the equity market.

Perhaps the authors’ most important finding was of “a significant price-destabilizing effect” from sell herding, suggesting “that institutional sell herding could pose substantial risks to financial stability.” They found that “while buy herding is associated with permanent price impact that facilitates price discovery, sell herding results in transitory yet significant price distortions and therefore excess price volatility.”

A Sizable Effect
Cai, Han, Li and Li noted that the impact of institutional herding on long-term corporate bond returns is substantial: “When investors herd to sell, bond prices fall substantially during the event period but reverse gradually over the following quarters. A contrarian portfolio that is long in bonds with the highest sell herding measures and short in bonds with the highest buy herding measures generates a cumulative abnormal return of 2.5% in six quarters after portfolio formation. Such an abnormal return is entirely driven by subsequent return reversals in bonds that experience heavy sell herding in the event period.”

They add that this evidence is consistent with evidence from equity markets, though the impact on bond returns is much stronger in magnitude. Finally, the authors noted that the “price destabilizing effect of sell herding is particularly strong for high-yield bonds, small bonds, and illiquid bonds, and during the recent global financial crisis. Specifically, the contrarian portfolio described above generates a cumulative abnormal return of 6% if constructed with high-yield bonds, 4% with small bonds, and 5% with less-liquid bonds, in six quarters after portfolio formation. If we focus on the 2007-2009 financial crisis period, the price destabilizing effect reaches 8%, much greater than that for the full sample period. Our results clearly point to the vulnerabilities associated with institutional sell herding in the corporate bond market, i.e., the price-destabilizing effect is strongest for the most risky bonds during periods of market distress.”

Conclusions

The authors concluded that the “price-destabilizing effect of sell herding is consistent with the predictions of herding caused by factors such as information cascades or reputation concerns. On the other hand, we find that buy herding improves price efficiency, consistent broadly with the fundamental-based herding theory.”

They also concluded that the reduced liquidity in corporate bond market herding may generate price distortions, and that market illiquidity may in turn induce herding (and its negative effects).

The corporate credit premium, as measured by the difference in returns between 20-year Treasury bonds and 20-year corporate bonds, has been only 0.3%. And that’s even before implementation costs (the costs associated with paying a mutual fund to gain the diversification benefits required when investing in bonds with default risk) that can be avoided when investing in Treasurys.

It also ignores the significant premium that FDIC-insured CDs typically carry relative to Treasurys. That evidence, along with the asymmetric and historically uncompensated call risk, has led my firm’s investment policy committee, generally, to recommend avoiding investments in corporate bonds. This study provides further support for that strategy.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.