Institutional Herding and Its Price Impact: Evidence from the Corporate Bond Market

Abstract

Among growing concerns about potential financial stability risks posed by the asset management industry, herding has been considered as an important risk amplification channel. In this paper, we examine the extent to which institutional investors herd in their trading of U.S. corporate bonds and quantify the price impact of such herding behavior. We find that, relative to what is documented for the equity market, the level of institutional herding is much higher in the corporate bond market, particularly among speculative-grade bonds. In addition, mutual funds have become increasingly likely to herd when they sell, a trend not observed among insurance companies and pension funds. We also show that bond investors herd not only within a quarter, but also over adjacent quarters. Such persistence in trading is largely driven by funds imitating the trading behavior of other funds in the previous quarter. Finally, we find that there is an asymmetry in the price impact of herding. While buy herding is associated with a permanent price impact that is consistent with price discovery, sell herding results in transitory yet significant price distortions. 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.

Is the Price Right? Swing Pricing and Investor Redemptions

“…Feroli et al (2014) illustrate how a growing fund industry may intensify the risk of concerted selling by fund managers in response to a perceived tightening of monetary policy, such as during the taper tantrum. These concerns echo the findings in studies on the herding behaviour of institutional investors (e.g., Cai et al (2016)), and the references therein), which may propagate illiquidity across financial markets as documented in, for example, Manconi et al (2012) or Jotikasthira et al (2012). While our paper is not concerned with interactions among fund managers, our conceptual framework takes into account the adverse effect of fund sales on market liquidity.…”

Do Buy-Side Institutions Supply Liquidity in Bond Markets? Evidence from Mutual Funds

“…That is, the typical mutual fund sells (buys) a bond when other market participants also sell (buy) the bond. The bond market literature has identified many explanations for mutual funds to trade in the same directions, including herding behavior of institutions(Cai, Han, Li, and Li (2016)), index rebalancing (Dick-Neilsen and Rossi (2016)), credit rating events (Ellul, Jotikasthira and Lundblad (2011)), among others. Results in Panel A indicate that the average LS_score exhibits variation over time.…”

“…The opposite is classified as liquidity demand. Change in bond holdings that do not coincide with an inventory cycle, or meet a minimum overlap threshold are reported as unclassified.7 The bond market literature has identified many explanations for mutual funds to trade in the same direction, including herding behavior of institutions(Cai, Han, Li, and Li (2016)), index rebalancing (Dick-Neilsen and Rossi (2016)), credit rating events(Ellul, Jotikasthira and Lundblad (2011)), among others.…”

Which Bonds to Sell in Fire Sales? Liquidity Versus Commonality of Holdings

“…Our paper is also related to the literature that studies correlated trading among financial institutions (Chiang and Niehaus, 2016;Cai et al, 2016). We provide a new rational explanation of correlated selling, namely the failure to fully account for the negative externality of selling on other institutions.…”