Corporate bond fund investors react badly, if intelligently, to losing money which may mean some bond funds run into and also cause trouble when a selloff in illiquid markets starts.
Given two trends – one towards lower bond market liquidity and and other of surging investment in corporate bond funds – this could end up being a big story.
From 2008 to 2014 funds invested in corporate bond mutual funds nearly tripled to more than US$1.8trn. That’s part of an overall drive towards more exposure to fixed income, but also got a push from regulatory and market changes making money market funds less attractive.
At the same time, dealers working under new tighter regulations are no longer willing to hold as much inventory.
A new study, one of the first to look at the issue, shows that corporate bond investors behave very differently from their equity fund peers.
Equity fund investors are like dogs chasing cars, they bound after them if they go fast but show little idea how to handle matters if ever the car stops and they catch up.
Good performance drives money into equity funds, but investors show surprisingly little sensitivity to bad performance.
This implies that equity funds have little potential to cause damaging sell-offs themselves and as such pose little threat to the real economy.
Bond fund investors, in contrast, are very sensitive to bad performance, and tend to pull money quickly from funds when things get hairy, according to the study.
“Overall, our empirical results suggest that corporate bond funds are prone to fragility,” Italy Goldstein, of The Wharton School, Hao Jiang of Michigan State University and David Ng of Cornell University write in the preliminary paper released in April.
In part, the authors argue, this may be because of the illiquidity of the corporate bond market, and of many bond funds.
Corporate bond funds quote prices daily, and allow investors to redeem their shares at the quoted value. That means, in a corporate bond fund with illiquid assets, if I sell up today it may drive down the price of the remaining assets in the fund, dealing a loss to remaining fund holders tomorrow.
Bank run behaviour
The study found that corporate bond funds with lower asset liquidity tended to show magnified flows out during times of falling prices.
Similarly, during times of stress for the market generally, when assets tend to become more illiquid, this self-reinforcing negative spiral is stronger.
Looking at the “Total Return” funds family, which suffered sharp outflows when Bill Gross left PIMCO last year, the authors found that a sub-fund which was more liquid was the only one of the four which didn’t see a sharp spike in withdrawals.
Interestingly, if you want to invest in a corporate bond fund and are worried about illiquidity, try to invest alongside institutional investors. They exhibit less of the self-reinforcing behaviour, perhaps because they can and do take a longer view.
The worry here is not simply that you as an investor in a corporate bond fund might face a vicious cycle of losses, but that the incentives inherent in the system could cause far-reaching trouble.
“The illiquidity of their assets seems to create strategic complementarities that amplify the response of investors to bad performance or other bad news. These ‘run’ dynamics are very familiar from the banking context, and recently were on display in the run on money market mutual funds following the collapse of Lehman Brothers,” the authors write.
Remember, corporate bond funds own about 23% of all corporate bonds, so the potential for a self-reinforcing spiral is there. This in turn could obviously disrupt other markets.
And while this danger is clearly driven by a set of poorly designed incentives, it also strikes me that it may in part reflect a difference in nature and objective between bond and equity investors.
Retail bond investors, being by nature a more conservative group, may simply be more sensitive to losses, though less prone to chase the latest hot sector or fund.
The issue raises two sets of questions. Firstly, the sector seems ripe for regulatory change to, as the authors put it, “achieve the value from intermediation by corporate bond funds while minimizing the damage from fragility.”
Secondly, there is the risk versus reward question for investors, especially given the generally low compensation on offer from corporate bonds.
Given a fragile, illiquid market, low returns and the potential for the kind of trouble which drives tight correlation, now may not be the time for corporate bond funds.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
