Institutional investors such as pension funds and insurers hold a significant proportion of global equity and bonds. Their investment behaviour is therefore considered to be a decisive factor in price movements on financial markets. In the context of the European sovereign debt crisis, regular studies were also conducted to determine whether these investors have contributed to market instability.
A new DNB study examines the extent to which Dutch pension funds exhibit herding behaviour in sovereign bonds investments, and whether this has a stabilising or a destabilising effect on the sovereign bond market, during both crisis and non-crisis periods. Herding behaviour occurs if many pension funds purchase significantly more or fewer sovereign bonds from a particular country at the same time than can be reasonably expected under certain market conditions. If pension funds copy each other's investment decisions, herding behaviour has a destabilising effect – distorting the market. However, if investment transactions are based on pension funds processing new information at the same time, herding has a stabilising effect – demonstrating that the market is functioning properly. This does not alter the fact that bad news can in any case still lead to a fall in prices. The study was based on an analysis of monthly data over a six-year period for transactions by the 67 largest Dutch pension funds which involved sovereign bonds from 109 countries.
Extent of herding behaviour
Herding in purchasing was measured by expressing as a percentage the extent to which more pension funds purchased sovereign bonds from a particular country than can reasonably be expected under certain sovereign bond market conditions. If many sovereign bonds were in any case purchased in a particular month, then an adjustment was made. Herding in selling was measured in the same way. The study revealed strong herding behaviour of 16% for Dutch pension funds selling sovereign bonds, and 12% for purchases of sovereign bonds. This implies that for a particular country, 16% more pension funds sell sovereign bonds than on average, and 12% more purchase sovereign bonds. Moreover, this herding behaviour is almost five times as intensive as the levels indicated in the international scientific literature for potential herding in equity transactions (3%).
Underlying causes of herding
To gain a better understanding of the underlying causes of herding behaviour, we observe how these transactions relate to the associated macroeconomic and financial circumstances, or pension fund characteristics. Herding appears to increase with lower sovereign ratings of countries, when macroeconomic and financial conditions are less favourable, and when there is greater political instability. It also occurs more often for countries with relatively small sovereign bond markets, and for countries in which pension funds have relatively few bond holdings. This behaviour is therefore more prevalent for smaller, less stable and less developed countries. Herding also presents an option to reduce information costs for small portfolios. The results of the analysis suggest that this last factor possibly plays a role: for small portfolios of smaller or less well-developed countries, it is more economical to follow other pension funds than to obtain expensive information. In that light, it is logical that the small pension funds are more likely to exhibit herding behaviour than larger pension funds.
Do pension funds' investments have a stabilising or a destabilising effect?
As mentioned, herding is stabilising if it is caused by pension funds processing new information at the same time, but it can have a destabilising effect if it is merely the result of imitating other pension funds' investment behaviour in the absence of relevant information. Under normal circumstances, we can to a limited extent observe destabilisation, although under extreme market situations – namely exceptionally high or low yields– it does have a stabilising influence. One explanation for this could be that in extreme market situations, pension funds rebalance their portfolios by conducting transactions more intensively to ensure their portfolio reflects their strategic investment allocation. If bond values increase due to declining interest rates, then pension funds will sell some of the bond holdings on their balance sheets. As a result of this, bond values will again go down. Most pension funds follow this investment strategy, and were therefore revealed to exhibit herding behaviour in the study. In terms of general prosperity, this market stabilisation – which occurs when the need is most acute – is positive.