Abstract - The Role of Bond Markets When Portfolio Choice is Constrained

The impact of regulatory changes-such as tightening or loosening leverage restrictions on institutional investors-depends materially on the market environment at the time of implementation. Focusing on bond markets in a dynamic equilibrium setting, this paper shows that if regulation is tightened at times when investment opportunities are perceived to be good (thus being constrained is particularly onerous), the constrained investors tilt their portfolio towards few risky assets at the expense of diversification, leading to rising interest rates. If the tightening of regulatory constraints is undertaken when the leverage constraint binds less severely, the opposite occurs: risky substitute investments are less sought after, and the higher demand for safer bonds lowers the interest rate. This finding suggests that the timing of regulatory initiatives plays a crucial role in how constraints spill over into different markets. A related result on bond yield differentials across countries indicates that when investor-specific constraints lead groups of investors to specialize into certain asset markets, cross-country interest rate differentials are more volatile than they would be in the absence of constraints.

Astrid Schornick
16.Nov 2010

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