Finance and Economics Discussion Series (FEDS)
Investment Commonality across Insurance Companies: Fire Sale Risk and Corporate Yield Spreads
Vikram Nanda, Wei Wu, and Xing Zhou
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
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