Nº 21-07: Institutional Corporate Bond Pricing

The corporate bond market, dominated by institutional players such as insurance companies, pension funds, and mutual funds, is a critical source of funding for U.S. corporations. We assess the impact of shocks to financial institutions on the costs of debt financing, such as credit spreads, by estimating an equilibrium demand-based corporate bond pricing model. To that end, we first compile a rich novel dataset connecting institutional investors’ holdings to corporate bond characteristics and estimate their equilibrium demand functions. We find significant heterogeneity in demand elasticities across major institutional investors. With low interest rates, mutual funds increasingly seek liquidity in corporate bond markets, with short investment horizons and high demand elasticities, akin to a reaching for yield, which is provided by insurance companies with inelastic demand. In counterfactual equilibrium simulations, we evaluate the corporate bond pricing implications of i) mutual fund fragility and bond fire sales, ii) monetary policy tightening through rising rates, and iii) a tapering of the Fed’s corporate credit facility, among others. While the latter’s effects appear modest, our model predicts substantial disruptions in corporate bond prices for the former two scenarios through shifts in institutional demand. In equilibrium, such disruptions are reflected in the real economy through firms’ financing decisions. Our model thus emphasizes the composition of institutional demand as an important state variable for corporate bond pricing.