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1 February 2014 CFA Institute Journal Review

The Supply and Demand Factor in the Bond Market: Implications for Bond Risk and Return (Digest Summary)

  1. Marc L. Ross, CFA

Using market segmentation and a preferred-habitat hypothesis to buttress their argument, the authors devise and implement a model to explain the effects of supply and demand factors on bonds.

What’s Inside?

The authors develop a methodology to better understand the relationship between the preferred-habitat hypothesis for the term structure of interest rates and supply and demand in bond markets. Given the manner in which it conducts its monetary policy, China’s government provides an ideal environment for the authors’ research because it lends itself to preferred-habitat investor behavior.

How Is This Research Useful to Practitioners?

Standard models of the term structure of interest rates assume perfect markets. The authors’ research takes into account the effects of supply and demand on bond performance with the goal of providing a tool to enable better fixed-income portfolio performance. Their preferred-habitat construct distinguishes the aforementioned role of supply and demand from that of alternative investment opportunities in bond pricing. Implementation of the model helps the authors investigate the role of supply and demand in fixed-income pricing and performance.

Because emerging markets are a fertile ground for the evaluation of the effects of supply and demand on bond performance, the authors introduce their own preferred-habitat model into this environment. Their efforts concentrate on China’s government bond market. The advent of commercial banking in the mid-1990s in China saw big banks lending to mostly state-owned enterprises, with little consideration given to credit risk. After the Asian financial crisis, many of these institutions experienced defaults in their loan portfolios. These banks’ subsequent purchases of low-risk government paper were intended to mitigate the problem because these instruments were liquid and could substitute for surplus funds or meet liquidity demand. These events led to the creation of not only the interbank bond market but also more fixed-income vehicles, as well as greater trading volume. The commercial banks’ behavior is that of preferred-habitat investors seeking bonds as investment substitutes for bank loans. Such banks then act as arbitrageurs when they engage in liquidity management.

Applying their model in this context, the authors illustrate that yields on alternative investment opportunities benefit bond yields, whereas demand from preferred-habitat investors and arbitrageurs negatively affects bond yields.

Fixed-income portfolio managers, analysts, and traders will doubtless find the implications of this work to be of merit in determining how the preferred-habitat theory affects the term structure of interest rates and, in turn, enables bond portfolio managers to achieve better results. The changes in ownership structure imply a considerable impact on tax revenue. This result, in turn, should be incorporated into discussions about appropriate tax and retirement policy.

How Did the Authors Conduct This Research?

Reviewing the limited literature on the subject of the effect of interest rate term structures on the demand for bonds, the authors develop an affine preferred-habitat term structure model that assumes the presence of (1) preferred-habitat investors that trade bonds with specific maturities that satisfy specific time horizons and (2) arbitrageurs that invest in bonds of varying maturities with the objective of mitigating risk. They then refine the model by introducing state variables and the explanatory effects of the role of preferred habitat and arbitrage on bond demand and pricing. They apply the model to the burgeoning bond market in China, a rich dataset that is increasingly in the sights of fixed-income portfolio managers.

The authors use monthly data from 2000 to 2011 and regress market interest rates on a preferred-habitat factor (the average of official lending interest rates at different maturities) and a demand factor (the difference between bank deposits and loans). They find that the official bank lending rates affect market interest rates positively but the demand factor displays a negative effect on them. In the affine preferred-habitat interest rate model that the authors develop and implement, these two factors—along with two latent factors—are shown to have significant predictive powers that are superior to those of previous models and that support the preferred-habitat hypothesis.

Abstractor’s Viewpoint

The results of the authors’ research underpin the use of the preferred-habitat theory to better understand bond-pricing dynamics and to model bond yields and returns. Their research will ideally lead to better fixed-income portfolio management. An application of the authors’ research to different bond markets, with adjustments to their methodology to accommodate circumstances perhaps less ideal than those in China’s government bond market, would be interesting.

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