Measuring The Impact Of Mutual Funds On Bonds


Shane Worner, Senior Economist, IOSCO examines the impact of asset management flows on bond market liquidity.
In the wake of the crisis of 2008, many economies implemented accommodative monetary policies to help alleviate some of the worst effects of the fallout. These accommodative monetary policies have increased the liquidity of primary market corporate bond issuances, driving down interest rates and ultimately lowering the cost of borrowing associated with corporate bonds.
However, with the US Federal Reserve signalling the normalisation of interest rates, there is continuing concern that the secondary market liquidity has failed to keep up with primary market liquidity and is prone to evaporation. Also in doubt is whether the changing structure of the secondary market will stand up in a stressed scenario. Given their importance to corporate bond markets, the driving factors behind these concerns deserve a closer look.
Secondary bond market measures
There are a number of traditional measures of secondary market liquidity including: trading volume; bond turnover ratio; dealer inventories of corporate bonds; the bid-ask spread and price impact; and data on trade size. However, many are telling an inconsistent story. Trading volumes in secondary markets have been increasing (see Figure 2), while the bond turnover ratio (BTR), on the face of it, shows secondary market liquidity declining (See Figure 3). However, the BTR is biased by a skewed denominator effect. The BTR captures secondary market turnover as a proportion of primary issuances. With record primary issuances, the data highlights that in fact it’s not a question of “less secondary market activity”, but rather of higher primary issuances that have outpaced trading.
Additionally, the decline since 2008 in dealer bank bond inventories has been citied as another indication that secondary market liquidity and the functioning of corporate bond markets have declined. Figures 4 and 5 highlight large declines in net positions since 2008. However, it is not clear from this data what proportion were corporate bond holdings. In an IOSCO research department report, Corporate Bonds: A Global Perspective, 1 the authors also noted that the data on net positions pre-2013 include other types of corporate credit, such as asset and mortgage backed securities, whose issuance declined rapidly after the onset of the crisis and as new regulations were introduced. This trend mirrored a similar decline in dealer net positions.
Economic theory would dictate that any unusual developments in secondary market liquidity should flow through to the price of executing a transaction. The bid-ask spread is such a measure, but Figure 6 shows the bid-ask spread has in fact decreased since 2008.
The age of asset management
Against this backdrop, assets under management in the funds industry have grown since the crisis of 2008.
Although growth has broadly been across all fund assets classes, in an environment of low interest rates and yield search, many illiquid asset classes, such as emerging market debt and high yield bond funds, have seen increases in assets under management, while offering daily redemption facilities. Consequently, concerns relating to potential systemic risks associated with the activities of asset managers in less liquid asset classes have been at the fore of financial stability discussions in recent years.2
The concern primarily centres on how the activities of funds will interact with potentially less liquid bond markets. In an environment of rising interest rates, bonds fund performance would suffer, due to capital losses. In response, and perceiving some so-called “first mover advantage”, unit holders will try to redeem, en masse, potentially forcing funds to liquidate their holdings in illiquid markets, amplifying price falls and thereby creating a price decline spiral. This is just one of many other plausible scenarios. Data indicates, though, that bond mutual funds generally experience greater net inflows than outflows and, as the ICI has pointed out, redemptions tend to be quite sticky, especially for retail investors.

Additionally, it is important to consider several other factors. First, asset management is just one actor within the corporate bond market space. Based on Figures 8 and 9, bond funds make up a small proportion of global market bonds sales. Second, the investor composition of the market is an important consideration. We would be less concerned with an investor composition that has a buy to hold strategy than one focused on trading.3
In an attempt to tackle this issue, the US Securities and Exchange Commission’s Division of Economic and Risk Analysis published a staff paper, which examined the US mutual fund industry with particular attention to fund flows, the liquidity of fund portfolios, and the interaction of those characteristics. The SEC staff noted that mutual funds in investment categories that hold potentially less liquid assets are growing quickly and often have volatile flows. Alternative strategies have both the highest average net flow and the highest average net flow volatility of any investment category. Among many other empirical results, the analysis showed that the liquidity of the equity portfolio of US equity funds is greater when flow volatility is greater and that the liquidity of those same portfolios decreases after large outflows. While the SEC staff analysis of the US fund industry provides significant insight into recent experience with equity portfolios, gaps in our understanding regarding vulnerabilities associated with asset managers remain.
On one side of the coin, corporate bonds remain a popular vehicle for corporations to finance themselves. On the other side, those same corporate bonds remain quite attractive to end-investors, including mutual funds, but concerns about how the two could interact in stressed times remain.
It is important to take a holistic approach to the markets, and consider all actors and the substantial changes in the market environment caused by unprecedented monetary policy, a significant wave of reforms, and heightened innovation.
Significant data gaps exist, leaving important questions unanswered. As highlighted above, the debate around a lack of secondary market liquidity in corporate bond markets is by no means finalised. Nor is the debate on the role of funds´ interaction in this market. Many significant options exist in the asset management industry (such as internal liquidity management practices including stress testing) and regulatory policy tools that aid fund managers in meeting this liquidity mismatch and redemptions.
Data also show that mutual funds generally experience greater net inflows than outflows and, in aggregate, enjoy a stable investor base. Additionally, funds’ investments in portfolio assets do not currently represent a large portion of the market for these assets as a whole.
IOSCO is continuing to work on a number of these issues, alongside other standard setters, namely the Basel Committee for Banking Supervision (BCBS), the Committee for Payment and Market Infrastructures (CPMI) and the International Association of Insurance Supervisors (IAIS). Furthermore, IOSCO is contributing to the work of the Financial Stability Board (FSB), as well as doing work directly for the G20 Leaders, to address these emerging issues.
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