Board of Governors of the Federal Reserve System

June 2017

Investment Commonality across Insurance Companies: Fire Sale Risk and Corporate Yield Spreads

Vikram Nanda, Wei Wu, and Xing Zhou

Abstract:

Insurance companies often follow highly correlated investment strategies. As major investors in corporate bonds, their investment commonalities subject investors to fire-sale risk when regulatory restrictions prompt widespread divestment of a bond following a rating downgrade. Reflective of fire-sale risk, clustering of insurance companies in a bond has significant explanatory power for yield spreads, controlling for liquidity, credit risk and other factors. The effect of fire-sale risk on bond yield spreads is more evident for bonds held to a greater extent by capital-constrained insurance companies, those with ratings closer to NAIC risk-categories with larger capital requirements, and during the financial crisis.

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Keywords: capital constraints, corporate bonds, credit rating, fire sales, insurance companies, regulation, yield spread

DOI: https://doi.org/10.17016/FEDS.2017.069

PDF: Full Paper