Staff Working Paper No. 803
By Yuliya Baranova, Graeme Douglas and Laura Silvestri
We build a framework to simulate stress dynamics in the UK corporate bond market. This quantifies how the behaviours and interactions of major market participants, including open-ended funds, dealers, and institutional investors, can amplify different types of shocks to corporate bond prices. We model market participants’ incentives to buy or sell corporate bonds in response to initial price falls, the constraints under which they operate (including those arising due to regulation), and how the resulting behaviour may amplify initial falls in price and impact market functioning. We find that the magnitude of amplification depends on the cause of the initial reduction in price and is larger in the case of shocks to credit risk or risk-free interest rates, than in the case of a perceived deterioration in corporate bond market liquidity. Amplification also depends on agents’ proximity to their regulatory constraints. We further find that long-term institutional investors (eg pension funds) only partially mitigate the amplification due to their slower-moving nature. Finally, we find that shocks to corporate bond spreads, similar in magnitude to the largest weekly moves observed in the past, could trigger asset sales that may test the capacity of dealers to absorb them.