Simulating Stress in the UK Corporate Bond Market: Investor Behaviour and Asset Fire-Sales

55 Pages Posted: 15 Jun 2019

Date Written: June 14, 2019

Abstract

We build a framework to simulate stress dynamics in the UK corporate bond market. This quantifies how the behaviours and interactions of major market participants, including open-ended funds, dealers, and institutional investors, can amplify different types of shocks to corporate bond prices. We model market participants’ incentives to buy or sell corporate bonds in response to initial price falls, the constraints under which they operate (including those arising due to regulation), and how the resulting behaviour may amplify initial falls in price and impact market functioning. We find that the magnitude of amplification depends on the cause of the initial reduction in price and is larger in the case of shocks to credit risk or risk-free interest rates, than in the case of a perceived deterioration in corporate bond market liquidity. Amplification also depends on agents’ proximity to their regulatory constraints. We further find that long-term institutional investors (eg pension funds) only partially mitigate the amplification due to their slower-moving nature. Finally, we find that shocks to corporate bond spreads, similar in magnitude to the largest weekly moves observed in the past, could trigger asset sales that may test the capacity of dealers to absorb them.

Keywords: corporate bond market, fire-sales, open-ended investment funds, pension funds, insurance companies, dealers, stress simulation

JEL Classification: G10, G20

Suggested Citation

Baranova, Yuliya and Douglas, Graeme and Silvestri, Laura, Simulating Stress in the UK Corporate Bond Market: Investor Behaviour and Asset Fire-Sales (June 14, 2019). Bank of England Working Paper No. 803 (2019), Available at SSRN: https://ssrn.com/abstract=3404234 or http://dx.doi.org/10.2139/ssrn.3404234

Yuliya Baranova (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Graeme Douglas

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Laura Silvestri

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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