Abstract
ABSTRACTThis paper studies reaching for yield—investors’ propensity to buy riskier assets to achieve higher yields—in the corporate bond market. We show that insurance companies reach for yield in choosing their investments. Consistent with lower rated bonds bearing higher capital requirements, insurance firms prefer to hold higher rated bonds. However, conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. This behavior is related to the business cycle being most pronounced during economic expansions. It is also characteristic of firms with poor corporate governance and for which the regulatory capital requirement is more binding.
Highlights
Reaching-for-yield—investors’ propensity to buy riskier assets in order to achieve higher yields—is believed to be an important factor contributing to the credit cycle
Conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds
Regulation requires insurance companies to maintain minimum levels of capital on a risk-adjusted basis, often called “RBC” or risk-based capital. (On average, 91% of all securities holdings by insurance companies are in fixed income (Nissim, 2010) making the treatment of fixed income the core component of the RBC calculation.) To determine the capital requirement for credit risk, corporate bonds are sorted into six broad categories (National Association of Insurance Commissioners, “NAIC”, risk categories 1 through 6) based on their credit ratings, with higher categories subject to higher capital requirement
Summary
Reaching-for-yield—investors’ propensity to buy riskier assets in order to achieve higher yields—is believed to be an important factor contributing to the credit cycle. We show that insurance companies, the largest institutional holders of corporate bonds, reach for yield in choosing their investments. Reaching-for-yield exists both in the primary and the secondary market, and is robust to a series of bond and issuer controls, including bond liquidity and duration, and issuer fixed effects This behavior is related to the business cycle, being most pronounced during economic expansions. Given the discrepancy between credit ratings and market perception of risk, reaching-for yield by fixed income investors evaluated and/or regulated based on credit ratings should show up conditional on such risk benchmark. (On average, 91% of all securities holdings by insurance companies are in fixed income (Nissim, 2010) making the treatment of fixed income the core component of the RBC calculation.) To determine the capital requirement for credit risk, corporate bonds are sorted into six broad categories (National Association of Insurance Commissioners, “NAIC”, risk categories 1 through 6) based on their credit ratings, with higher categories subject to higher capital requirement According to the U.S Flow of Funds Accounts, in 2010, their holdings represented $2.3 trillion, or more than bond holdings of mutual and pension funds taken together. Regulation requires insurance companies to maintain minimum levels of capital on a risk-adjusted basis, often called “RBC” or risk-based capital. (On average, 91% of all securities holdings by insurance companies are in fixed income (Nissim, 2010) making the treatment of fixed income the core component of the RBC calculation.) To determine the capital requirement for credit risk, corporate bonds are sorted into six broad categories (National Association of Insurance Commissioners, “NAIC”, risk categories 1 through 6) based on their credit ratings, with higher categories subject to higher capital requirement
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