Bo Becker and Victoria Ivashina
Reaching for yield in the bond market
Journal of Finance | Volume 70, Issue 5 (Oct 2015), 1863–1902

A key principle of finance is that evaluations and comparisons of returns are only meaningful after adjusting for risk. However, risk is often hard to measure. This creates an important limitation in the delegation of investment decisions. Financial intermediaries that are evaluated based on imperfect risk metrics face an incentive to buy assets that comply with a set benchmark but have “hidden risk.” In other words, imperfect benchmarks may create incentives to “reach for yield” in the context of fixed-income investing, or to “search for alpha” more generally. This could lead to excess risk-taking in financial institutions, persistent distortion of investments and, potentially, amplification of the overall risk in the economy. Indeed, reaching-for-yield is believed to be one of the core factors contributing to the buildup of credit that preceded the recent financial crisis (Yellen [2011] and Rajan [2010]).

We study “reaching for yield” in the corporate bond market. We show that insurance companies—the largest investor in bonds—reach for yield in choosing their investments.

Insurance companies' capital requirements allow reaching for yield within ratings buckets

Insurance companies in the U.S. face capital requirements that depend on the credit ratings of fixed income securities in their portfolios. Bonds are grouped in broad buckets based upon credit ratings; bonds in these groupings face similar capital requirements. For the best bonds, rated AAA down to A-, the requirement is 0.30% of face value (an insurance company needs 30 cents of equity for every $100 of book value of bonds in this range of ratings). For bonds rated BBB, the capital requirement is 0.96% of book value; for BB, 3.39%; for B 7.38%; for CCC 16.96%; for with a rating below CCC, the capital requirement is 19.50

Given these rules, insurers could reach for yield by selectively buying the riskiest bonds within a given category, thus increasing the risk of the portfolio without raising capital requirements. We demonstrate that this is indeed what happens. We first show that in thirteen quarters leading to the financial crisis (2004:Q2 to 2007:Q2), insurers—as compared to pension funds and mutual funds—exhibit a strong preference for safer bonds, representing over 70% of institutional purchases of investment grade bonds. (See Figure 2.)

That is, across risk categories, insurers exhibit the risk aversion that capital requirements are meant to induce. Yet, within capital requirement buckets, the risk preferences are reversed. The share of newly-issued corporate bonds acquired by insurers in the same time frame increases in risk (as measured by yield to maturity at issue, or the CDS spread) within the AAA to A category (the same is true for BBB, but we lack a precise estimate for high-yield bonds, of which there are far fewer). (See Figure 3.) Thus, insurers appear to reach for yield in a way that is invisible to the standard metric on which they are evaluated. It is also characteristic of firms with poor corporate governance, and firms for which the regulatory capital requirement is more binding.

2: Insurance companies' holdings of newly issued corporate bonds
becker-ivashina-1-D
This shows corporate bond holdings 2004:Q2-2007:Q2, by rating category, for newly issued bonds. The horizontal axis shows holdings of insurance companies, relative to the sum of insurance companies, pension and mutual funds' holdings. The bars indicate 95% confidence intervals. Insurers buy very large shares of newly issued safe bonds (rated BBB and above) but avoid riskier (lower rated) bonds.

This result does not depend on comparing insurance firms to other investors. In the paper, we show that a similar pattern emerges when we look only at insurance firms' investment in a given bond over time, as its yield and CDS changes but its credit rating does not. The pattern is robust to inclusion of duration and liquidity controls. Importantly, we also show that this risk-taking is not “alpha,” i.e., superior investment ability. With various choices of benchmarks, we document that the abnormal return on the aggregate corporate bond portfolio of insurers is negative or zero.

Business Cycle and Crisis

Consistent with concerns that reaching for yield contributed to buildup of risk in the financial system and its consequent contraction, we show that insurers' reaching behavior is pro-cyclical. In particular, reaching-for-yield behavior disappears during the most recent financial crisis and comes back in the second half of 2009, as documented in Figure 3.

The Impact of Reaching for Yield

The impact of reaching for yield is to increase risk taking. We find that the firms with the most reaching tended to do worse in the financial crisis of 2008. For example, AIG, which was noted for its aggressive managing of regulatory capital, and which—as is well known—was at the center of the financial crisis, had one of the higher portfolio yields for corporate bonds among large insurance companies. In our regression analysis, we document that during the financial crisis, the drop in stock prices for publicly traded insurance companies was deeper for those with less owner oversight (as measured by the number of block holders). This suggests that the risk-taking induced by reaching for yield may be undesirable for owners (which likely implies that it is not good for society at large either), and may contribute to cyclicality in credit markets.

On the other hand, reaching for yield has broad implications for the credit supply. Firms that happen to belong to the favored “buckets” (high-risk firms with “A” ratings on senior debt, for example) would be able to borrow at better terms relative to other firms. Indeed, we document that bond issuance by riskier firms coincides with times of pronounced reaching for yield by insurance firms.

3: Reaching for yield over time
becker-ivashina-1
This figure shows the reaching for yield by US insurance companies (the strength of insurance companies' preference for higher-yielding investment grade bonds within ratings categories) by quarter. Reaching for yield peaked in 2006 and early 2007, disappeared in the crisis, and then returned as financial markets recovered in 2009.

Final Thoughts

Just like regulation based on ratings, delegated management—which is based on credit ratings—may incite reaching for yield within rating buckets. Portfolio managers can raise the promised yield on a bond portfolio by taking more credit risk. As long as securities do not default, this additional yield improves performance relative to benchmarks, and reported profits are raised. To the extent that reported profits are more visible than the credit risk in bond portfolios, owners may misunderstand actual performance of managers that reach for yield.

While we study insurance companies and risk assessment based on credit ratings, in all likelihood, the reaching for yield we document for insurance firms and corporate bonds happens in other parts of the financial system. All in all, reaching for yield is an ongoing phenomenon hardwired into financial intermediation by imperfect risk measurement. Illiquid and complex securities are particularly prone to this issue. Weak incentives and regulation that reduces visibility or discourages assessment of risk by outside claimholders exacerbate this problem.