“What Explains Preferred Habitat? Insights from Insurers’ Treasury Bond Portfolios” by Tong Yu
University of Rhode Island
An explanation of the term structure of interest rate is the preferred habitat theory. Under this theory, investors have distinct investment horizons and it takes extra premiums to lure investors into bonds of non-preferred maturities. To date empirical evidence on preferred habitat is sparse. In this study, we present comprehensive evidence on preferred habitat by investigating the Treasury bond duration choices of an important group of bond investors — property liability insurance companies. We model insurers' portfolio durations as a partial adjustment process toward unobservable target durations and empirically estimate the model. The findings confirm the presence of preferred habitat. First, durations of insurers' Treasury bond portfolios and expected claim payments are positively correlated, consistent with the duration matching hypothesis. Second, durations of insurers' Treasury bond portfolios are positively correlated with insurers' risk taking ability and the income gap between premiums and claim costs. Finally, firms may deviate from targets if bond returns offered at non-preferred maturities are sufficiently high.