The Effect of Long-term Investor Demand on the Long End of the Yield Curve: "A Preferred Habitat Analysis of the Yield Curve”

Abstract

In this thesis, we conduct an empirical analysis of the effect of demand for long-term safe assets of the Pension and Insurance (P&I) sector on the yield spread on long-term government bonds. We identify a negative effect of the size of the P&I sector on the long-end of the yield curve. This effect is predominantly present in periods of high risk aversion, indicating support for the preferred habitat theory. By allowing for a longer investment-horizon preference, the one-factor term structure model indicates a level effect on the long rate caused by an increasing P&I sector, providing further support for the preferred habitat theory. The largest effect stems from investments in the Defined Contribution (DC) scheme pension funds and lifeinsurance companies. The effect from the DC scheme is primarily located at the yield spread between 20-year and 10-year government bonds. This effect coincides with the primary effect from publicly issued bonds, compared to pension investments as a whole, that are also reported to have the largest effect on the yield spread between the 20-year and 10-year government bonds, indicating that despite the larger degree of investment freedom, DC scheme pension funds have a demand for government bonds. Collectively, these results may have large implications for risk taking in a world with increasing longevity affecting the size of the P&I liabilities.