I have a question based on reading some speeches and research papers, mainly by Ben Bernanke, on the portfolio balance effect. Here is Bernanke in a recent paper he authored where he describes the portfolio-balance effect as one of the two principal channels of large-scale asset purchases:
"The portfolio balance channel depends on the premise that securities are imperfect substitutes in investors’ portfolios, reflecting differences in liquidity, transactions costs, information, regulatory restrictions, and the like. Imperfect substitutability implies that changes in the net supply of a security affect asset prices and yields, as investors must be induced to rebalance their portfolios (Bonis et al., 2017). In principle, the two channels of QE can be distinguished by the fact that the signaling channel operates by affecting expectations of future policy rates while the portfolio balance channel works by changing term and risk premiums."- Bernanke (2017), in a paper that can be located here: https://www.brookings.edu/wp-content/uploads/2017/10/bernanke_rethinking_macro_final.pdf
I'm having some trouble here understanding the finance of this. In particular, how does this channel necessitate imperfect substitutability? I understand that the argument hinges on 'habitat preferences' -- certain investors prefer, say, a specific type of security -- but I haven't been able to put the pieces together.
As a potential example: let's say that we have an investor who will only deal with 5-year Treasury bonds due to either preference, risk appetitive, liquidity requirements, and so forth. The Federal Reserve then purchases 5-year Treasury bonds. Bernanke seems to suggest that the reason that reductions in the supply of these securities will increase their prices and reduce their yields is that investors don't view other securities as perfect substitutes. Is the argument perhaps that, if our investor considered 7-year bonds a perfect substitute, the increase in the price of the 5-year bond would cause him to sell off his supply of 5-years for a significant capital gain and purchase some other security? Or, for that matter, his portfolio would consist of such a wide array of different maturities that buying 5-year bonds wouldn't impact his behavior at all, as he would just replace it with any other bond.
I know this has something to do with elasticity of demand, but I just haven't been able to piece together the logistics of imperfect substitutability, hopefully, leading to a rebalancing of investor portfolios and a decline in interest rates across asset classes in a broad-based way.
I'd appreciate any insights people might have on this.