Bond investors are no longer behaving in accordance with a long-established theory in investing, according to new research published by Touro College professors Kenneth Dreifus and Angelo DeCandia. Their work, published in the journal Business and Economic Research, could have ramifications on the way the Federal Reserve manages interest rates.
According to Professor Dreifus, bonds are a fixed income investment, meaning the issuer – typically a corporation or government seeking to finance a project – promises to pay the investor a specified rate of interest during the life of the bond and to repay the principal. Investors like bonds because they provide a predictable income stream, as opposed to more volatile stock holdings. When bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.
Professors Dreifus and DeCandia along with Professors Elliot Goldberg and Mohammed Chowdhury looked at the “Preferred Habitat Theory (PHT),” which suggests that bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference under very specific conditions. In other words, bondholders prefer certain maturity and they will leave that maturity only if given the proper incentive.
The researchers conducted a qualitative study of twenty bond traders and compliance officers to test the validity of PHT. After the data was collected, the responses were analyzed using statistical analysis software.
A Theory Disproved
The researchers speculated that the bond investors are now trading across all maturities, and the widely accepted theory of “preferred habitat” is no longer consistent with actual practice. Additionally, the flattening nature of the yield curve may be forcing bond traders out of preferred habitats because there is almost no way to hedge if you stay only in one area of maturity.
While previously it may have been easier to predict how bond investors would behave, it now seems they will trade wherever they can make money.
Most responses in the study indicated that the ability (or need) to profit took preference over dogma. As Professor Angelo DeCandia notes, “our paper shows that investors will not easily abide by decisions of the Federal Reserve but will shift maturities depending on their ability to earn bond trading profits. That makes things a little less predictable for the Fed, economists, and the rest of us.”
Professor Kenneth Dreifus adds, “It also means that the introductory Economics and Finance textbooks need to be revised to deal with this new reality.”
It may be difficult for the Federal Reserve to get people to invest in long-term projects, since there appears to be little incentive to do so when the returns are the same on short-term investments. This evidence is essential information for institutional bond investors (e.g. investment banks, money managers, hedge funds), but it has ramifications for the average person shopping for car loan or mortgage, as it will be harder to predict interest rates. It may also be harder to get a 30-year fixed rate mortgage, as lenders can’t be guaranteed their loan will earn more interest than on deposits.