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On “institutional herding”

Herding denotes broad uniformity of buying and selling across investors. If the transactions of one institution encourage or reinforce those of another, escalatory dynamics, liquidity problems, and pricing inefficiencies ensue. A Federal Reserve paper (which I noticed belatedly) provides evidence of herding in the U.S. corporate credit market during the 2003-08 boom-bust experience, particularly during sell-offs. Bond herding seems to be stronger than equity herding. Subsequent to herding dynamics price reversals have been prevalent, consistent with the idea of temporary price distortions.

“Institutional Herding in the Corporate Bond Market, Board of Governors of the Federal Reserve System, International Finance Discussion Papers Number 1071, December 2012

The below are excerpts from the paper. Headings and cursive text have been added. 

Institutional herding and the coporate bond market

“By definition, institutional herding is a trading pattern where institutional investors buy or sell the same set of securities at the same time. Herding has been commonly regarded as a key characteristic of institutional trading. Most studies…focus on the equity markets and report that institutional herding is very low in general, and moderate for only some segments of the markets with relatively low liquidity or information transparency.”

“The market for the U.S. corporate bonds is large and dominated by institutional investors. As of the end of 2010, institutional investors held about three quarters of the USD7.5 bn outstanding corporate bonds issued by U.S. firms…Unlike the markets with organized exchanges, corporate bonds are mostly traded in the over-the-counter (OTC) markets. Because OTC markets are generally viewed to have low liquidity and high information asymmetry, the results of existing studies suggest that herding may be more significant in the corporate bond markets.”

Evidence for herding

“We adopt the herding measures proposed by Lakonishok, Shleifer, and Vishny, [estimating]…the unusually correlated trades of certain securities among a group of investors. We find substantial institutional herding in U.S. corporate bonds [for 2003 – 2008], much higher than that previously documented in the equity markets.”

“Herding is significantly stronger on the sell-side [i.e. during sell-offs] than on the buy-side [i.e. rallies]…Also, the levels of both buy and sell herdings are substantially stronger in the corporate bond market than their counterparts even for small stocks.”

“Buy herding and sell herding are driven by different factors…

  • Within a quarter, buy herding increases with post-trade transparency, i.e., following the dissemination of trade information by TRACE [Trade Reporting and Compliance Engine], buy herding increases significantly. [Also] we find that over quarters, there is a strong correlation between current trading and past trading of others.
  • Sell herding increases on negative news about bond ratings and corporate earnings. Herding is stronger in bonds that are smaller, lower-rated, with higher information asymmetry…This result is consistent with previous studies that bond investors use generally buy-and-hold strategies and bias to sell when there is bad news on a bond’s credit risk.”

Liquidity and reversals

“The relationship between herding and bond liquidity seems to be U-shaped rather than monotonic. Herding is highest among most illiquid bonds, but also high among bonds that are most liquid. The U-shaped relationship between liquidity and herding is interesting, as it likely mirrors the trade-off between the benefit from information based herding and the transaction cost of herding. On the one hand, trades on illiquid bonds are more likely to contain more private information, and making herding a more effective trading strategy, on the other, illiquid bonds are more costly to trade, making the strategy less profitable. Thus, only very liquid bonds (low transaction cost) or very illiquid bonds (high private information) are herded upon.”

“We find significant return reversals in the post-herding trades, especially for sell herding…In terms of post-herding price dynamics, prices revert after three quarters among the sell herding portfolios, with the abnormal returns…This finding suggests that sell herding in the U.S. corporate bond market destabilizes bond prices. Price reversal is most prominent when funds herd to sell illiquid bonds, which suggests that temporary price pressure is the reason behind price reversal.”


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