Fixed Interest Rate Market Anomalies – A Behavioral Finance Perspective
Behavioral finance is a field of economics that blends principles of psychology with financial theory. It assumes that individuals may not always make rational financial decisions and market behavior decisions on their own; as they may be subject to influence by psychological factors and biases which influence these decisions and behaviors.
Understanding investor biases can assist advisors in making more sound investment decisions that are in line with clients’ long-term goals, and may explain persistent market anomalies and inefficiencies which challenge mainstream financial theories.
Understanding Anomalies
Market anomalies are periodic patterns found in markets that can be exploited for profit, although it’s important to remember that such strategies don’t always work and you should only risk small sums of money at any one time.
Many of the most notable recurring anomalies can be linked to calendar events. Examples include The January Effect (where investors repurchase tax losses from previous months), weekend effects and turn-of-the-month effects.
Another type of market anomaly involves mismatch between expectations and actual interest rates in the market – known as a yield curve inversion – and actual rates. An inverted yield curve has serious ramifications for businesses and consumers as it decreases banks’ borrowing ability at short-term rates to fund loans at short terms rates.
Mispricing, unmeasured risk and arbitrage restrictions are some possible explanations for market anomalies; others could include selection bias which occurs when some data is deliberately excluded from an analysis.
Observing Anomalies
The Efficient Market Hypothesis (EMH) and Behavioral Finance both rest on the assumption that all market participants act rationally with the goal of optimizing risk-adjusted returns and no practical frictions stand in their way of reaching this objective. Unfortunately, differing objectives and frictions often result in market anomalies.
Investors could, for instance, systematically switch their holdings away from low yield securities in favor of those with higher returns, thus artificially inflating the price of low-yield assets until they no longer represent economic value in comparison with newly issued issues and must thus decline in order to entice new investors.
Investor behavior also causes stock prices to appear to follow a stationary general-mean-reversed (GMR) model instead of random walks; cointegrate together instead of moving independently; and lead to momentum anomaly: where stocks that have recently performed better outperform those which have seen poor recent performances.
Managing Anomalies
In recent years, anomalies have reappeared in fixed income markets, often stemming from relatively high valuations susceptible to sudden selloffs from low interest rate expectations combined with elevated levels of volatility and concerns about global growth and central bank policies.
Other anomalies result from specific investor biases. For example, Winner-Loser Effect and Momentum Anomalies both suggest investors buy past “winners” while selling off past “losers.” Such anomalies seem to contradict finance theory which stipulates prices should rise only in response to new information; however duration-matched adjustments for interest rate changes seem to reduce or eliminate most anomalies that violate market efficiency forecasts.
Studies involving investor surveys have also demonstrated how apparent investor biases may lead to anomalies. These may include overreacting to news, reversing momentum, herding effects; value and size anomalies, the equity premium puzzle and calendar anomalies such as January effect reversals or weekend effect calendar anomalies. According to behavioral finance theories these anomalies should eventually dissipate when investors trade in line with their risk preferences.
Managing Risk
Contrary to equity markets, fixed income markets are characterised by an array of participants who frequently buy and sell bonds (and related interest rate derivatives) for reasons other than maximising profits. This may include banks managing their balance sheets, governments financing budgets, passive investors tracking benchmarks, insurers matching liabilities and central banks fulfilling policy objectives.
Persistent anomalies over recent years include widening cross-currency basis swap spreads and negative US dollar interest rate swap spreads, reflecting widening global financial risks, including counterparty risk and funding liquidity shortages in certain currencies, as well as changes in dealer institutions’ behaviour which has seen less focus on arbitraging anomalies away.
Behavioral Finance theories provide explanations for these anomalies, with Markowitz (1952a) proposing his portfolio optimization theory on the assumption of investors with a symmetric utility function; however, more realistic models such as those developed by Tobin (1958) and Wong (2007) reveal how investors with asymmetric utilities may still manage to optimize their portfolios using different selection rules.
