Procyclical Asset Management and Bond Risk Premia

Abstract

Research questionInstitutional investors, such as banks, insurers, endowments or foundations, often delegate their assets to third-party investment management companies who set up institutional funds. These funds are an important group of financial intermediaries: available estimates from the US and Europe suggest that institutional funds manage more money than retail mutual funds. Yet, despite their economic significance, little is known about how institutional funds invest and how their trading affects asset prices. Since they cater to sophisticated clients with a long-term investment horizon and rarely use leverage, one would expect institutional funds to invest less procyclically than highly levered institutions or retail funds which typically face strong flow-return relationships. ContributionWe use granular data on the security holdings of all German institutional investment funds to study their investment behavior. We examine to what extent and how funds reallocate their portfolios in reaction to changes in interest rate spreads. Moreover, we analyze the relation between institutional funds' trading and bond prices by using security-level variation in the demand of institutional funds, controlling for the demands of all other types of institutional investors. We test explicit and implicit incentives in the fund sector as explanations for institutional funds' investment behavior. ResultsWe document that institutional funds' trading is strongly procyclical: they actively turn to higheryielding, longer-duration and lower-rated assets as yield spreads compress, and vice-versa. Despite their different liability structure, institutional funds invest as procyclically as the retail funds in our sample. Moreover, even in highly liquid markets, this procyclicality has persistent price impact and contributes to asset price swings. We partly attribute the procyclical investment behavior to fund managers facing explicit incentives such as capital guarantees and implicit incentives such as yield targets and career concerns. Our findings highlight that strongly procyclical investment behaviour can exist even in the absence of observable short-term funding constraints and leverage.