Corporate Bond Funds Are Weak Where They Look Weak: Researchers

Corporate bond funds that look shaky have been wobbling harder than stronger-looking bond funds.

Three economists have published data supporting that observation in a new working paper on financial fragility in the corporate bond markets.

Antonio Falato, who's an economist at the Federal Reserve Board, and two colleagues, Itay Goldstein and Ali Hortaçsu, considered several different bond fund risk indicators, and looked at how those indicators correlate with bond fund asset flows since worries about the pandemic, and pandemic-related economic uncertainty, began squeezing world investment markets.

The economists found that bond mutual funds, and exchange-traded funds that invest in corporate bonds, that seem riskier suffered much more dramatic asset outflows than bond funds and bond ETFs that seem as if they would be more stable.

Resources

A link to the Falato team's paper is available here.
A 2020 bond market preview article, posted Dec. 30, 2019, is available here.

Falato and his colleagues have posted the working paper on the website of the National Bureau of Economic Research, in front of the NBER's usual paywall.

A working paper is an academic paper that has not yet been through a full academic peer review process.

The paper may be of interest to professionals in the life insurance and annuity sectors for two reasons.

One is that life insurers themselves have experimented with investing some of their assets on bond funds.

A second reason is that some life insurers have investment management arms that offer bond funds.

A third reason is that financial professionals who are selling annuities, or life insurance-based retirement planning arrangements, may find themselves competing with financial professionals who promote use of bond funds as retirement savings and retirement income planning tools.

Financial professionals to prefer bond funds to life- and annuity-based arrangements may tell clients that bond funds are better because bond funds give retirement savers easier access to their money.

Falato's team contends that bond fund liquidity may have its limits.

The economists cite Mark Carney, the governor of the Bank of England, who "warned that investment funds that include illiquid assets but allow investors to take out their money whenever they like were 'built on a lie' and could pose a big risk to the financial sector," the economists write.

Study Details

Falato and his colleagues note that U.S. bond fund assets have grown dramatically since the 2007-2009 Great Recession, and that, up till now, many new, rapidly growing bond funds have not faced major stress events.

"Hence, while fragility of corporate-bond investment funds could be detected, there was no evidence to test their resilience in large stress events," the researchers write.

The researchers split the crisis period into several different phases, and they looked at a number of different potential sources of bond fund fragility, including a fund's liquidity levels, a fund's age, the average duration of a fund's assets, and the percentage of a fund's assets that were tied to sectors hit hard by the COVID-19 lockdowns.

The researchers assumed, for example, that relatively cash-poor funds, new funds, funds with many long-duration bonds, and funds with many bonds issued by hotel chains and airlines would face worse asset outflows than average bond funds.

Every potential source of fragility the researchers checked did actually seem to correlate with increased asset outflows during the worst days of the spring crisis.

The researchers used several different indicators to measure a bond fund's liquidity, for example, One was bond ratings, and another was the typical size of the gap between bid and ask prices for a bond fund.

Between February and March, because of COVID-19, the average bond fund studied experienced a cumulative 9% loss of net asset value, the researchers write.

The funds that ranked in the bottom 25% in terms of liquidity experienced a 19% loss of net asset value.

Similarly, the researchers write, younger bond funds suffered outflows that were about three times the size of outflows at other funds, and funds with longer-duration bonds suffered outflows that were five times as large as the outflows at other funds.

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