Skittish investors seeking safety have poured a lot of money into corporate bond mutual funds in recent years. Which raises the question: What happens when that flow reverses?
In their paper, “Investor Flows and Fragility in Corporate Bond Funds,” Wharton finance professor Itay Goldstein, and co-authors Hao Jiang of Michigan State and David Ng of Cornell, studied the flows in performance of those mutual funds to determine what impact heavy withdrawals can have on individual funds, the bond market, and the broader economy. In this interview with Knowledge@Wharton, Goldstein explains what they learned.
An edited transcript of the interview appears below.
A Question of Fragility:
Assets of mutual funds that invest in corporate bonds have grown substantially in recently years. Following the crisis, many investors felt that they did not have many attractive investment vehicles. And a lot of money has basically flown into mutual funds that invest in corporate bonds. Now this poses a very interesting challenge for researchers. For many years, there has been a lot of research studying mutual funds that invest in equities. But there hasn’t been that much research looking into mutual funds that invest in bonds, and in particular in corporate bonds.
Now there’s a growing concern of fragility — the possibility that a lot of this money is going to be withdrawn at the same time from many mutual funds, as a result effecting the prices of corporate bonds, and potentially destabilizing the market for them. And having also some real effects for the economy as a whole.
As a result there is, I think, growing importance to understand the patterns of flows and performance of mutual funds that invest in corporate bonds, and this is what we do in this study
The Opposite of Equity Mutual Funds:
Previous research on equity mutual funds basically showed that outflows are not very sensitive to bad performance. What we show in the context of corporate bond mutual funds is that outflows are much more sensitive to bad performance. In fact, outflows are more sensitive to bad performance than inflows are to good performance, which is the complete opposite of what people tend to find in the context of equity mutual funds.
In the context of fragility, this raises the concern that in case of bad performance or overall bad times, there will be massive outflows from the corporate bond mutual funds. Now, clearly given that this is an industry that holds about $1.7 trillion in assets, this is a reason for concern or reason to watch out and see what’s going to happen in case of bad developments.
“People view mutual funds as being very different from banks. Investors put the money in the fund and get whatever is the value of the assets when they take the money out.”
As I mentioned, there was a lot of research on equity mutual funds basically showing that inflows are much more sensitive to good performance than outflows are to bad performance. We did not know what to expect going into the research on corporate bond mutual funds. And we found the opposite, that outflows are much more sensitive to bad performance than inflows are to good performance. I’m not sure if I would call it a surprise, but it was a very interesting finding, I think.
Less Liquidity, More Sensitivity:
We think that the sensitivity of outflow to bad performance in corporate bond mutual funds is coming due to the fact that they hold illiquid assets. But at the same time, they allow people and institutions to take money out on a daily basis, based on the last updated price. What we show in the research is that this sensitivity depends greatly indeed on the illiquidity of the assets. So for example, funds that hold more cash are less subject to this great sensitivity of outflows to bad performance. And this is because if you have more cash, then investors know that they depend less on the withdrawals by others. And as a result, they’re less keen to take their money out once there are bad developments.
In the same vein, we basically showed that the sensitivity goes up when illiquidity is great at the macro level. This can be measured by the VIX, for example, which is a measure of overall volatility, and other measures of aggregate illiquidity. Basically, what we show is that funds that invest in more illiquid assets or during more illiquid times are going to be more subject to greater sensitivity from outflows to bad performance. This is something that we can think of as more fragility. You can address this fragility by holding more liquidity or changing the way that investors take money out, whatever the redemption formula is, whatever they get out of the fund in case they take the money out.
“Given that this is an industry that holds about $1.7 trillion in assets, this is a reason for concern.”
The First-mover Advantage:
I think that there is an overall perception that mutual funds are not subject to any kind of fragility. People view mutual funds as being very different from banks. Investors put the money in the fund and get whatever is the value of the assets when they take the money out. I think our paper sheds some more light on it, basically showing that there is some potential for fragility — there is some of this first-mover advantage that we tend to see in the context of banks. This is because when people take their money out of the fund, they impose some negative externalities on those who stay in the fund. This is amplified by illiquidity, and as a result you tend to see this first-mover advantage amplifying the incentive of people to take their money out in case of bad performance.
Breaking New Ground on Bonds:
This is basically the first paper that looks at the sensitivity of outflow to performance in corporate bond funds. As I said, corporate bond funds have become a very important investment vehicle in the economy in recent years. It’s important to understand what causes withdrawals out of these mutual funds. And as far as I know we are the first paper to look at that and analyze it. We basically document that there is some sense of fragility in the sense that people, when they think that others are going to take their money out of mutual funds that invest in corporate bonds, have greater incentive to do that as well.
“What we show in the research is that this sensitivity depends greatly indeed on the illiquidity of the assets.
The Risk of a Bond Fund ‘Bank Run’:
In this paper we basically look at fragility at the level of the fund. We show that there is a first-mover advantage at the level of the fund, in the sense that if investors think that other investors are going to take their money out of the mutual fund, they have a greater incentive to do so as well. This is kind of similar to the phenomenon that is well known as a bank run. People take money out of a bank just because they expect other people will do that. We think something similar, maybe weaker, happens in the context of mutual funds, in particular those that invest in corporate bonds, because corporate bonds tend to be very illiquid. So this force is going to be stronger.
Implications for Intervention:
Going further, one wants to look more at systemic implications — the extent to which this puts the economy as a whole, or the market as a whole, in a tough position, in a risky position. This will be particularly important for policy implications. So far, as I mentioned, we only look at it at the level of the fund. And we think there is this force, the first-mover advantage at the level of the fund itself. But policy intervention will only be required in case this also poses externalities on the rest of the economy, externalities that fund managers themselves are not going to internalize and are not going to address.
A paper on this research titled “Where have all the Investment dollars gone? A brief on the developments and potential fragility in Corporate Bond Markets” was published by the Penn Wharton Public Policy Initiative.