The Bond Pricing Implications of Rating-Based Capital Requirements
126 Pages Posted: 28 Jun 2017 Last revised: 22 May 2019
Date Written: May 17, 2019
This paper demonstrates that rating-based capital requirements, through their impact on insurers' investment demand, affect corporate bond prices. Consistent with insurers’ low demand for investment-grade (IG) bonds with a rating close to non-investment-grade, these bonds are underpriced. Consistent with insurers’ high (low) demand for IG bonds with high (low) systematic risk exposure, these bonds are overpriced (underpriced). Insurer demand, measured by insurer holdings, explains most of these pricing effects. We identify rating-based capital requirements as the driver of insurer demand, and thus the pricing effects, by showing that the effects do not exist before these requirements' implementation in 1993.
Keywords: Risk-based capital, regulatory arbitrage, insurance companies, corporate bonds, credit ratings, systematic risk, asset pricing
JEL Classification: G11, G12, G14, G21, G22, G28
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