On the Relative Performance of Investment‐Grade Corporate Bonds with Differing Maturities

Date01 December 2017
Published date01 December 2017
AuthorFei Leng,Gregory Noronha,Darrin DeCosta
DOIhttp://doi.org/10.1111/fima.12167
On the Relative Performance
of Investment-Grade Corporate Bonds
with Differing Maturities
Darrin DeCosta, Fei Leng, and Gregory Noronha
Wef ind that short-maturity investment-grade corporate bonds perform better, controlling for risk
differences,than similar bonds with longer maturities. Our results are at least partially attributable
to insurance companies’ trading behavior and align with the preferred-habitat theory of the term
structure. We find that insurance-company purchases createa strong demand for long-term bonds
and that their rebalancing activity results in sales of short-term bonds. As documented by extant
literature, such demand-supply imbalance is not easilyresolved by arbitrageurs or firms seeking
to time the market with bond issuance.
Studies of the preferred habitat theory of the term structure of interest rates introduced by
Culbertson (1957) and Modigliani and Sutch (1966) have primarily focused on the government
bond market and few, if any, attempts have been made to apply it to corporate bonds. One
premise of this theory is that investors have strong maturity preference in their choice of bonds.
While this effect has been well documented in the government bond market (Greenwood and
Vayanos, 2010; Krishnamurthy and Vissing-Jorgenson, 2011), there have been no inquiries into
other bond markets. In this paper, we attempt to ascertain whether such an effect exists in the
investment-grade corporate bond market and, if it does, to identify the investor clientele.
We use a sample of investment-grade, option-free, corporate bonds to construct portfolios
according to bond maturities. We find that Sharpe ratios of the shorter maturity portfolios are
higher than those of longer maturity portfolios. This pattern persists even after we double sort the
bonds according to their credit quality and issuer sector. To further control for bond characteristics
other than term to maturity,we match short-term bonds with longer term bonds according to sector,
credit score, and average monthly trading volume. We find that portfolios with short maturity
bonds have significantly higher Sharpe ratios than matching portfolios composed of longer term
bonds. We present evidence that this finding is not merely an artifact of a similar effect in
the Treasury bond market as documented by Duffee (2011). We then use a factor regression
model, which controls for the bond factors of term, default and liquidity, to demonstrate that
portfolios consisting of short-term corporate bonds have positive and significant alphas. As the
term to maturity of portfolios increases, the outperformance disappears. Overall, our findings
are supportive of the thesis that short-term bonds have better risk-adjusted performance than
otherwise similar long-term bonds. We conduct a number of robustness checks on our findings,
but they remain qualitatively unchanged.
Weare grateful forhelpful comments from an anonymous referee. Wealso thank participants at the Financial Management
Association Annual Meeting (2014) for their comments and suggestions.
Darrin DeCosta is a Managing Director at LadderRite Portfolios LLC in Naperville, IL. Fei Leng is an Associate
Professor of Financein the Milgard School of Business at the University of Washington Tacoma in Tacoma, WA. Gregory
Noronha is the Russell Endowed Professorof Finance in the Milgard School of Business at the University of Washington
Tacoma in Tacoma, WA.
Financial Management Winter 2017 pages 839 – 872
840 Financial Management rWinter 2017
Next, we explore possible driversof the maturity-related perfor mance differential in corporate
bonds. Based on the fact that insurance companies are major participants in the investment-grade
corporate bond market in that they both hold and transact in proportionately large dollar amounts
of these bonds, we study their transaction data.1We find a clientele effect. Since they must
match the risk profiles of their assets to those of their long-term liabilities, insurance companies
exhibit a strong demand for longer term bonds and tend to sell shorter term bonds to rebalance
their portfolios as bonds approach their maturity.2Moreover, life insurers differ from nonlife
insurers in their demand for bonds with different maturities. Specifically, the data indicate that
life insurers engage in significant net sales of bonds with six years or less to maturity, while
nonlife insurers exhibit significant net sales of bonds with no more than three years to maturity.
While all insurers exhibit strong demand for bonds with 10 years to maturity, only life insurers
exhibit significant demand for bonds with more than 15 years to maturity.
To further verify that the maturity-related bond performance differential is related to the bond
trading behavior of insurance companies, we design a strategy that trades against the bond
transactions of insurance companies. Specifically, if insurance companies, in aggregate, engage
in a net purchase of a bond, we sell and include the bond in our short position portfolio. That is,
we take the position of issuing the bond. If insurance companies, in aggregate, have a net sale of
a bond, we purchase and include it in our long position portfolio. That is, we buy and hold the
bond. Using bond factor regressions, we document positive abnormal returns for this long-short
strategy.This result suggests that the demand-supply imbalance induced by insurance companies’
bond transactions is significant enough to distort bond prices and contribute to the superior
performance of short-term bonds relative to longer term bonds. Additionally, we demonstrate
that while trading against insurance companies generates positive abnormal returns, a parallel
strategy using bonds that do not exhibit the insurer-induced demand-supply imbalance fails to
produce positive alphas. This provides further support to the premise that insurance companies’
bond market behavior contributes to the outperformance of shorter term bonds. Further analysis
indicates that it is primarily life insurers who contribute to the demand-supply imbalance and
that other types of insurance firms have an inconsequential effect. Overall, our results based on
insurance companies’ bond transactions indicate that the high levels of demand for investment-
grade corporate bonds at the long end of the maturity spectrum, coupled with high levels of
sales at the short end, creates an imbalance that drives up the prices of long-term instruments
relative to those of short-term ones contributing to the superior risk-adjusted performance of
1According to Capital Markets Special Reports published by NAIC’s Capital Markets Bureau (June 2015), as of year-end
2014, 67.0% ($3.86 trillion) of the US insurance industry’s$5.76 trillion asset portfolio was in bonds with 53.4% ($2.06
trillion) in corporate bonds, 14.0% ($0.54 trillion) in municipal bonds, 6.3% ($0.24 trillion) in Treasury securities, 2.7%
($0.10 trillion) in foreign government bonds, 16.1% ($0.62 trillion) in mortgage-backed securities, 6.8% ($0.26 trillion)
in asset-backed securities and other structured securities, and the rest in hybrid securities. The insurance industry’s
holding of corporate bonds grew steadily from nearly $1.5 trillion in 2004 to over $2 trillion in 2014. In 2014, 94%
of the bonds held by the insurance industry were investment-grade and this percentage has remained stable over time.
Insurance companies do not hold a large proportion of their assets in Treasury securities due to the relatively low yield
on Treasuries. Collectively, insurance companies hold 30% to 40% of all investment-grade corporate bonds (Schultz,
2001; Campbell and Taksler,2003). Due to the predominant content of investment-grade bonds in their asset portfolios,
insurance companies’ influence on this market is much greater than their influence on other bond markets. Forthis reason,
we confine the scope of our study to investment-grade corporate bonds and the findings of the paper reflect a unique
institutional characteristic of the market for these bonds.
2Rather than selling shorter term bonds out of their portfolios, insurance companies can also choose to hold these bonds
until maturity. However, they do not generally adopt this alternative as it would significantly lower the duration of the
asset portfolio. If they choose to hold bonds to maturity, insurance companies wouldneed to buy a signif icant amount of
very long-term bonds to balance out the resulting duration compression. However,the choices and amounts of long-term
corporate bonds available are limited as most corporate bonds are issued at 10 years, or less, to maturity.
DeCosta, Leng, & Noronha rRelative Performance of Investment-Grade Corporate Bonds 841
these short-term bonds.3Our analysis does not attempt to ascertain, in an absolute sense, whether
it is shorter term bonds that are underpriced or longer term ones that are overpriced. Our f indings
only suggest that shorter term bonds are relatively underpriced in comparison to longer term
ones.
Since it is both common knowledge and clear from our data that there are investors, insurers
in this case, with strong demand for long-term bonds, it is natural to ask why arbitrageurs do
not take advantage of the situation or why issuers (suppliers) of these securities do not act to
satisfy the demand for long-dated bonds and restore an equilibrium where risk-adjusted returns to
short-term bonds are no different from those at the long end of the term structure. The literature
on preferred habitat theories of the term structure, the relative supply of long-term government
debt (Treasuries), shifting credit market conditions, and constraints on market timing by firms
suggest that equilibrium may be difficult to restore and maintain.
The preferred habitat behavior of insurance companies, in general, and life insurers, in partic-
ular, has support in ideas originally introduced by Culbertson (1957) and Modigliani and Sutch
(1966) and more recently formalized in models by Vayanos and Vila (2009) and Greenwood
and Vayanos (2014). Although this literature focuses largely on government bonds, the principal
arguments are extendible to investment-grade corporate bonds as well. One natural question in
preferred habitat theory is why mispricing induced by clienteles with bond maturity preferences
is not eliminated by arbitrageurs. Vayanos and Vila’s (2009) model predicts that when market
imperfections, such as capital constraints, interact with arbitrageurs’ risk aversion, risk concerns
prevent arbitrageurs from completely eliminating clientele-induced bond mispricing. Greenwood
and Vayanos (2010) use the 2004 UK pension reform and the 2000–2001 US Treasury buyback
program as supporting examples of the preferred habitat effect and the incomplete elimination
of mispricing in the government bond market. Consistent with this, Krishnamurthy and Vissing-
Jorgenson (2011) find that following quantitative easing in 2008–2011 where the supply of
long-term Treasuries was reduced, long-term yields fell relative to short-term yields—a finding
they attribute to the demand for safe assets of specific maturities. More recently, D’Amico and
King (2013) provide empirical evidence of a local supply effect that supports preferred habitat
and imperfect substitution in the Treasury market.
When compared with the Treasuries, corporate bonds are less liquid, shorting them is more
difficult, and differences in liquidity, issue size, credit quality, and maturity, among others,
renders them anything but uniform. Further, there is no futures market for corporates. These
greater imperfections over the Treasury market make it much riskier to attempt arbitrage in
corporate bonds and to correct relative mispricing and restore equilibrium. However, this creates
an incentivefor the issuers of corporate bonds to time the market, therebylowering their borrowing
costs and filling the gap in the demand for long-dated bonds.
Indeed, Baker, Greenwood, and Wurgler (2003) find that the maturity of new corporate debt
issues predicts excess bond returns indicating that firms time the credit market by altering the
maturity of their debt. More recently, Greenwood, Hanson, and Stein (2010) find that corporate
issuers fill the maturity gap left by Treasuries and issue more long-term debt when the govern-
ment funds itself with more short-term debt, and vice versa. Even market timing behavior by
firms appears unable to eliminate relative mispricing between short- and long-dated bonds. The
3The large quantity of bonds availablefor sale at the shor t end of the maturity spectrum and concomitant price pressure
are also attributable to causes other than sales by insurance companies. Several popular investment-grade indexeshave
rules that require that they remove bonds that have less time to maturity than a predefined minimum threshold. Thus,
index-tracking bond funds are forced to sell these bonds contributing to the excess supply. See DeCosta, Leng, and
Noronha (2013) for details.

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