Essays on Institutions, Beliefs, and Asset Prices

Abstract

This dissertation comprises three chapters that examine the effect of institutional characteristics and preferences and investor beliefs on asset prices. I show that mixed bond mutual funds transmitted Quantitative Easing to the corporate bond market, dissect the composition of investor disagreement, and propose a risk premium resolution of the FOMC bond premium puzzle. In the first chapter, I study the transmission of Large-Scale Asset Purchase (LSAP) through financial investors’ balance sheets, illustrating the channel through US corporate bonds. Post-2008 LSAPs didn’t directly target corporate bonds, but cross-market investors might transmit the shock to corporate bonds through their portfolio adjustment behaviors. I show that mixed bond mutual funds, who I label as “switchers”, accommodated all three rounds of QE by selling Treasury securities and agency MBS. During the same period, “switchers” increased their corporate bond holdings by a total of 254.7 billion dollars. For two of the three rounds of QE, this switching behavior is associated with detectable price impacts on the corporate bonds that they held: for otherwise similar corporate bond issues, one percent higher ownership by “switcher” funds predicts 2.6 (1.0) basis points lower yield, eight quarters after the onset of QE2 (QE3). The effect is stronger at the firm level and concentrated in firms with speculative-grade ratings: for otherwise similar speculative-grade firms, one percent higher firm-wide bond ownership by “switcher” funds predicts 8.0 (8.4) basis points lower yield, eight quarters after the onset of QE2 (QE3). I show that these effects on risky asset prices affect firm borrowing decisions, as firms with higher “switcher” ownership had higher liability ratio and probability of issuing bond after QE2 and QE3. These effects on bond prices and firm borrowing decisions are not present in QE1 and placebo periods. In the second chapter, which is joint work with Robin Greenwood and Sam Hanson, we ask an empirical question: when investors disagree about the prospects of a firm, is it because they disagree about the industry or because of different assessments of the winners and losers in that industry? We decompose analyst disagreement about future EPS, Sales and Long-Term-Growth (LTG) into an idiosyncratic and an industry component. We show that the majority of disagreement is driven by the idiosyncratic component, meaning that investors mostly agree about industry prospects but disagree about which firms will perform the best within each industry. We present a model in which even idiosyncratic disagreement can have industry and market valuation effects. Even if investors agree on the prospects of the industry, in the presence of short-sales constraints the industry may be overvalued when investors disagree about the prospects of individual firms. We find evidence in future returns consistent with this idea. In the third chapter, I study the FOMC announcement premium for long-duration bonds, which is the fact that the average price return on 10-year nominal US Treasury securities during an FOMC announcement window (day before, day of, and day after an FOMC announcement) is 39 to 68 times that of a normal trading day (Hillenbrand [2023]). I present a model where risk aversion from a segment of the market (nervous sellers) drives the FOMC bond premium. Consistent with model predictions, bond returns are lower (not statistically significant) 2 days to 10 days before FOMC announcements. In addition, consistent with the model, the FOMC bond premium is higher when VIX is higher, realized variance of past bond returns is higher, and analyst forecast dispersion is higher. Using market-making data in the cash bond market from a large primary dealer, I examine investor flows around FOMC announcements. I find weak evidence that a subset of investors are persistent sellers of bonds before FOMC announcements, but the magnitude of nervous selling is too small to account for the FOMC bond premium.