Reaching for Yield in the Bond Market
Executive Summary — "Reaching for yield"—investors' propensity to buy high yield assets without regard for risk—has been identified as one of the core factors contributing to the buildup of credit that preceded the financial crisis. Despite this potential importance, however, the way in which reaching for yield works and where it occurs is not well understood. Professors Bo Becker and Victoria Ivashina examine reaching for yield in the corporate bond market by looking among insurance companies, the largest institutional investor in this arena. Findings suggest that reaching for yield may limit the effectiveness of capital regulation to a time-varying and unpredictable extent. Reaching for yield may also allow regulated entities to become riskier than regulators and legislators intend, and may impose distortions on the corporate credit supply. Key concepts include:
- Investments by insurance companies in corporate bonds exhibit patterns that reflect reaching for yield.
- Insurance companies are very important to the corporate bond market: According to U.S. Flow of Funds Accounts, insurance companies are the largest institutional holder of corporate and foreign bonds. Therefore, reaching may impact credit supply to the corporate issuers.
- Investment decisions of insurance companies are also important because, like banks, insurance companies have liabilities to a broad population base.
- Insurance portfolios are systematically biased toward higher yield bonds and higher CDS bond issuers. This behavior appears to be related to the business cycle since reaching for yield is most pronounced during economic expansions. It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding.
- Rules that discourage risk taking also provide incentives to reach for yield. Because imperfect risk measurement is itself a fundamental feature of financial markets, there are no easy fixes to reaching for yield.
Reaching-for-yield-the propensity to buy riskier assets in order to achieve higher yields-is believed to be an important factor contributing to the credit cycle. This paper analyses this phenomenon in the corporate bond market. Specifically, we show evidence for reaching for yield among insurance companies, the largest institutional holders of corporate bonds. Insurance companies have capital requirements tied to the credit ratings of their investments. Conditional on ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. This behavior appears to be related to the business cycle, being most pronounced during economic expansions. It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding. The results hold both at issuance and for trading in the secondary market and are robust to a series of bond and issuer controls, including issuer fixed effects as well as liquidity and duration. Comparison of the ex-post performance of bonds acquired by insurance companies does not show outperformance, but higher volatility of realized returns.