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ARCHIVE
Simulating a Crisis
By Sean Collins
August 15, 2017
The Bank of England (BoE) recently published a paper detailing results from a simulation intended to “stress-test” open-end investment funds. The paper suggests that under “severe but plausible” assumptions, investors could redeem so heavily from open-end investment funds (e.g., mutual funds or UCITS funds) during a period of market stress that they could cause “dislocations” in corporate bond markets.
As we have pointed out before, the hypothesis that investors in stock or bond funds might redeem heavily during a market downturn—thus destabilizing financial markets—is an old one, dating back to the 1920s. We’ve also noted that there isn’t much evidence of this, and that there is a fair bit of evidence against it.
Still, the BoE’s latest paper contends that if open-end bond funds saw redemptions equal to 1 percent of their assets over one week—about equal to aggregate outflows from European corporate bond funds during the depths of the financial crisis—then the yield spread between investment-grade corporate bonds and government bonds could increase by about 40 basis points (0.40 percent). Moreover, the paper says that slightly larger investor redemptions—1.3 percent of assets during a given week—could cause dysfunction in the corporate bond market.
The paper has attracted some attention in the media, and the BoE has solicited feedback. This ICI Viewpoints offers a preliminary discussion of some issues surrounding the BoE’s analysis.
The paper is “an incomplete exercise.” The BoE itself admits that its simulation model is a pilot step, “and so is an incomplete exercise.” It has some new and interesting features—such as seeking to model how readily hedge funds and dealers could in theory accommodate heavy sales of corporate bonds by open-end investment funds—but at this point, an in-depth critique is not possible because the paper provides too little detail (see below).
As the BoE itself acknowledges, it is too soon to use simulations like those in the paper to reach policy conclusions.
Assuming that correlation implies causation is a key concern. Bond fund flows are indeed correlated with bond market returns (see Figure 2.8 in the 2017 Investment Company Fact Book). But correlation does not mean causality. Researchers have sometimes assumed that this correlation arises because fund flows cause bond market returns to move and that the size of this causal “feedback” is measurable, known, and well-understood. But that’s not supported by empirical evidence.
In this case, it seems that the BoE’s model must make such an assumption—thus effectively driving its results—but unfortunately there’s not enough detail in the paper to confirm what assumptions the authors are using. For example, the paper does not spell out the assumptions in a key equation (equation 1 in Annex 1) that specifies how corporate bond prices are assumed to respond to funds’ sales of such bonds. The BoE should provide more details, so that stakeholders are better able to provide feedback.
The model appears to focus on euro-denominated corporate bonds. Somewhat curiously, given the BoE’s purview, its model appears to focus not just on sterling-denominated corporate bonds but also on euro-denominated corporate bonds. This makes a difference.
The solid gold line in Figure 1 below shows monthly flows to open-end bond funds that invest primarily in investment-grade corporate and government bonds denominated in either euros or pounds sterling. The pattern closely matches what the BoE’s paper depicts. As seen, outflows reached 4.7 percent of these funds’ assets in October 2008, the crisis month on which the BoE’s paper concentrates. The dashed blue line in the figure separates out monthly flows to open-end bond funds that invest primarily in investment-grade corporate and government bonds denominated only in pounds sterling. In that case, outflows in October 2008 were only 1.7 percent of those funds’ assets.
Figure 1: Estimated Net Flow to Investment Grade Corporate Bond Funds
Percentage of previous month-end total net assets; monthly, February 2007–September 2016
1Data include the following Morningstar categories, which had an average of 20 percent or more of their portfolios invested in corporate bonds as of March 2017: Convertible Bond–Europe, EUR Cautious Allocation, EUR Cautious Allocation–Global, EUR Corporate Bond, EUR Corporate Bond–Short Term, EUR Diversified Bond, EUR Diversified Bond–Short Term, EUR Flexible Bond, Europe Bond, GBP Cautious Allocation, GBP Corporate Bond, GBP Diversified Bond, and GBP Flexible Bond.
2Data include the following Morningstar categories, which had an average of 20 percent or more of their portfolios invested in corporate bonds as of March 2017: GBP Cautious Allocation, GBP Corporate Bond, GBP Diversified Bond, and GBP Flexible Bond.
Note: Data exclude money market funds, exchange-traded funds, and funds that invest primarily in other funds.
Source: Investment Company Institute tabulations of Morningstar Direct data
Why did funds investing in euro-denominated bonds have larger outflows? Government guarantees of banks may be one factor. In October 2008, many countries provided guarantees of banks, although details varied widely. Media reports indicate that guarantees introduced in Germany and Italy drew money from open-end bond funds into bank deposits. In addition, banks—which dominate retail sales of mutual funds on the European continent—may have pushed the sales of mutual funds to the sidelines, instead encouraging customers to place their assets in bank deposits, perhaps in an effort to shore up those banks’ deposits. These factors could help explain why outflows from UK-focused investment-grade corporate bond funds were more modest in October 2008.
Also, part of the outflows in October 2008 may have been a reaction to the stock market collapse that month. The BoE has defined an “investment-grade corporate bond fund” as one holding at least 20 percent of its assets in corporate bonds. As a result, some of the funds in the BoE’s analysis (and therefore also in Figure 1) hold a substantial portion of their assets in securities other than bonds (e.g., equities). It’s possible to avoid this issue by looking at the Morningstar GBP bond fund category, a category whose funds are available for sale in the United Kingdom and invest primarily in sterling-denominated corporate bonds. As Figure 1 shows, that category saw inflows during October 2008.
In other words, the BoE’s decision to include euro-denominated bond funds and funds that hold significant equity stakes clouds the analysis. We think the BoE should investigate these possibilities and fold them into its analysis. Alternatively, the BoE could avoid the issue altogether by refocusing its analysis exclusively on the sterling-denominated corporate bond market.
The paper links fund flows to corporate bond yield spreads, rather than corporate bond yields. The BoE’s model apparently simulates the effects of redemptions from open-end bond funds not on corporate bond yields, but on corporate bond yield spreads.
The difference is important. The corporate bond yield spread equals the yield on corporate bonds minus the yield on government bonds. Thus, during a crisis, corporate bond yield spreads may widen because corporate bond yields rise, because government bond yields fall, or some combination.
Generally, during periods of market stress, government bond yields will decline, reflecting the demand of all investors for the liquidity and safety of government bond markets. As a result, during periods of market stress, corporate bond yield spreads likely will widen even if open-end funds do not sell a single quid or euro’s worth of corporate bonds.
Figure 2: Yield-to-Maturity of UK Investment Grade Corporate Bonds and Gilt Bonds
Percent; daily, January 2, 2008–July 11, 2017
Source: S&P Dow Jones Indices LLC
To illustrate, in the United Kingdom in October 2008, investment grade corporate bond yield spreads widened significantly (to 95 basis points), but a significant portion (22 basis points) of the widening owed to a decline in government bond yields (see Figure 2, above). These effects were even more pronounced for the yield spread on euro-denominated investment-grade corporate bonds; by our calculation, that spread widened by 73 basis points in October 2008, of which the great majority (56 basis points) was due to a drop in government bond yields. We would recommend that the BoE clarify whether and how it deals with this issue.
The paper’s sensitivity analysis shows that assumptions matter. It is common with simulation models such as the BoE’s to provide a sensitivity analysis (i.e., to change a model assumption and see how the results vary). Though it would be preferable to see statistical confidence intervals around model results—is the probability of a 40 basis point increase in yield spreads 99 percent or is it 1 percent?—with these kinds of simulation models, a sensitivity analysis usually is all that can be done.
The sensitivity analysis in the BoE’s paper seems to suggest that the results are rather sensitive to the model’s assumptions. For example, the paper tests the model’s sensitivity to alternative assumptions about how funds meet redemptions. The baseline assumption is that funds meet redemptions by selling a vertical slice of their portfolios (i.e., they meet a 1 percent redemption by selling 1 percent of each bond issue that they hold). If the model instead assumes that funds partially use cash to meet redemptions (as is likely the case in practice), the predicted rise in corporate bond yield spreads is less pronounced (27 basis points instead of 40).
The BoE could check the sensitivity of its results to the factors we have discussed here. For example, it could ask, how do the results change if corporate bond funds see much smaller or no outflows, such as those seen in October 2008 in UK-focused corporate bond funds? Most importantly, though, the BoE should examine how its results would change if—as a range of papers have suggested—the correlation between bond fund flows and bond returns arises primarily from investors reacting to bond returns, rather than vice versa.
More work needs to be done. To reiterate, the BoE’s new model provides preliminary results—and it’s too soon (as the BoE itself emphasized) to use these simulations to reach policy conclusions. Hopefully, our analysis will help readers put the BoE’s paper in context, and provide useful suggestions for those who are examining stress testing of open-end investment funds.
Sean Collins is senior director, industry and financial analysis, at ICI.
TOPICS: Bond FundEuropeFinancial MarketsFinancial StabilityFixed IncomeFund RegulationGlobalInternationalMutual FundPolicy Research
What's the “Exposure” of Money Market Funds to Europe?
By Sean Collins
January 26, 2017
At the American Economic Association (AEA) meetings in Chicago early this month, speakers and attendees at several sessions asked: do money market funds pose systemic risks?
TOPICS: EuropeFederal ReserveFinancial MarketsFinancial StabilityFund RegulationInternationalMoney Market FundsMutual Fund
Matching Models to Reality: Doomsayers Are Disappointed—Again—as Funds Weather Brexit Shock
By Paul Schott Stevens
July 13, 2016
On Thursday, June 23, the electorate of the United Kingdom voted in a referendum on the country’s membership in the European Union. The result—51.9 percent in favor of “Brexit,” 48.1 percent in favor of “Remain”—went against pollsters’ and pundits’ expectations and surprised the world.
TOPICS: Bond FundEuropeFinancial MarketsFinancial StabilityFund RegulationICI GlobalInternationalMutual Fund
When Investor Protection Becomes Protectionism
By Patrice Bergé-Vincent
June 14, 2016
Today, Europe is facing two related needs: to provide its citizens with efficient, lower-cost vehicles for savings and investment, and to bolster economic growth.
TOPICS: EuropeFinancial MarketsFund RegulationICI GlobalInternationalMutual FundTaxes
Conducting Business in a Rapidly Changing World
By Jeanne Arnold
June 1, 2016
The global operating environment is evolving and it is critical for corporations to understand the changes afoot if they are to succeed in the 21st century, said Kevin Kajiwara, co-president of Teneo Intelligence, a division of global advisory firm Teneo. Speaking on the final day at ICI’s 58th General Membership Meeting (GMM), Kajiwara gave an overview of the economic and political shifts taking place around the world during his session, “Geopolitical Risks and the Global Economy.” After the overview, he engaged in an insightful question-and-answer session with Tom Faust, chairman and CEO of Eaton Vance Corp.
TOPICS: EuropeGMMInternationalMutual FundTrading
Derivatives—Please Don’t Let Them Be Misunderstood
By Shelly Antoniewicz
February 22, 2016
Derivatives are important portfolio management tools that provide funds with many potential benefits, including the ability to:
- hedge risk;
- enhance liquidity, because derivatives can be more liquid than traditional physical securities;
- gain or reduce exposure to unique markets or to asset classes when access through other instruments is difficult, costly, or impossible;
- manage or equitize cash; and
- reduce cost.
TOPICS: Bond FundBondsEuropeFinancial StabilityFund RegulationInternationalMutual Fund
U.S. and European Fund Investors Continue to Take Long View on EM Economies
By Chris Plantier
February 12, 2016
In an ICI Global Research Perspective last year, we showed that U.S. and European registered funds held $1.7 trillion in emerging market (EM) stocks and bonds at the end of 2014 (this total counts Hong Kong, Singapore, South Korea, and Taiwan as emerging markets). Of that, $1.27 trillion was estimated to be in equities and $431 billion was in bonds. We also showed that this $1.7 trillion was spread widely, across 80 different EM countries, and that fund net purchases of EM securities explained little of the variability of capital flow to EM countries.
TOPICS: Bond FundEuropeFinancial MarketsICI GlobalInternationalMutual Fund
Traders, Start Your Engines: After August 24, Exchanges Need to Coordinate
By Jennifer Choi and George Gilbert
November 30, 2015
The extraordinary volatility in U.S. equity markets on August 24, 2015, exposed a significant deficiency in the rules governing these markets’ structure: a lack of harmonization across securities exchanges for reopening trading after a “limit up–limit down” trading halt in a security.
TOPICS: Equity InvestingEuropeExchange-Traded FundsFinancial MarketsFinancial StabilityFixed IncomeFund Regulation
U.S. Bond ETFs Resilient on August 24
By Shelly Antoniewicz
November 20, 2015
Some observers have suggested that equity market volatility on August 24, 2015, spilled over into other markets and products, in particular to bond exchange-traded funds (see, for example, Bank of England Financial Stability Paper, no. 34, October 2015, pages 26 and 27). In our analysis of the events of that morning, we conclude that U.S. bond ETFs were resilient and largely immune to the turmoil in the equity markets.
TOPICS: Bond FundBondsEquity InvestingEuropeExchange-Traded FundsFinancial MarketsFinancial StabilityFixed IncomeFund Regulation
New York Times Paints False Picture of Funds’ Emerging Market Investments
By Mike McNamee
August 24, 2015
With the global market turmoil over the past week, it’s no surprise that journalists are looking for hot stories of panic, investor flight, and impending crisis. Either they believe that investors are inherently flighty and panic-prone, or they believe that “this time is different” and investors who have not panicked before will panic now.
TOPICS: Bond FundBondsEquity InvestingEuropeFinancial MarketsFinancial StabilityFixed IncomeICI GlobalInternationalMutual Fund
The IMF on Asset Management: Handle Empirical Results with Care
By Chris Plantier
July 15, 2015
In this ICI Viewpoints series, we’ve examined the wide range of data errors, inconsistencies, results that don’t bear statistical scrutiny, and misinterpretations in the International Monetary Fund’s most recent Global Financial Stability Report (GFSR)—specifically, the chapter on “The Asset Management Industry and Financial Stability.” Those problems primarily involved poor understanding of funds and their investors. We didn’t need advanced statistical methods to uncover them.
TOPICS: EuropeFinancial StabilityFund RegulationICI GlobalInternationalMutual FundTreasury
The IMF on Asset Management: Sorting the Retail and Institutional Investor “Herds”
By Sean Collins
June 4, 2015
Part of a series of ICI Viewpoints about problems in the IMF’s analysis of the asset management industry.
In this ICI Viewpoints series, we’re examining the wide range of data errors, inconsistencies, results that don’t bear statistical scrutiny, and misinterpretations in the International Monetary Fund’s April 2015 Global Financial Stability Report (GFSR)—specifically, the chapter on “The Asset Management Industry and Financial Stability.” These problems undercut the IMF’s conclusion that “Even simple investment funds such as mutual funds can pose financial stability risks.”
TOPICS: Bond FundBondsEuropeFinancial StabilityFund RegulationGovernment AffairsICI GlobalInternationalMutual FundPolicy Research
The IMF on Asset Management: Which Herd to Follow?
By Sean Collins
June 1, 2015
Part of a series of ICI Viewpoints about problems in the IMF’s analysis of the asset management industry.
In April 2015, the International Monetary Fund (IMF) published its most recent Global Financial Stability Report (GFSR), which included a chapter titled, “The Asset Management Industry and Financial Stability.”
We have heard suggestions from more than one observer that the IMF’s GFSR Chapter on asset management provides a wealth of charts, tables, and data to support regulators’ case that regulated funds or asset managers could pose systemic risks.
TOPICS: Bond FundBondsEuropeFinancial StabilityFund RegulationGovernment AffairsICI GlobalInternationalMutual FundPolicy Research
The IMF on Asset Management: The Perils of Inexperience
By Sean Collins
May 28, 2015
Part of a series of ICI Viewpoints about problems in the IMF’s analysis of the asset management industry.
In April, the International Monetary Fund (IMF) released its most recent Global Financial Stability Report (GFSR), including a chapter on “The Asset Management Industry and Financial Stability.”
TOPICS: Bond FundBondsEuropeFinancial StabilityFund RegulationGovernment AffairsICI GlobalInternationalMutual FundPolicy Research
SEC Chair White Affirms Agency Has Tools to Address Risks in Industry
By Rachel McTague
May 8, 2015
The U.S. Securities and Exchange Commission (SEC) has the tools it needs to address systemic risks to the extent they exist in the asset management industry, said SEC Chair Mary Jo White at the opening session on the final day of ICI’s annual General Membership Meeting (GMM). White also announced that David Grim—who had been serving as acting director of the SEC’s Division of Investment Management—has just been named director of the division. White said she is thrilled that Grim, a 20-year veteran of the SEC in the investment management area, is taking the reins at a time when the Commission is moving forward to implement proactive regulations for the industry.
TOPICS: BondsCybersecurityEuropeEventsExchange-Traded FundsFederal ReserveFinancial MarketsFinancial StabilityFund RegulationGMMGovernment AffairsInterest RateInternationalMutual FundShareholderTreasury
The IMF Quietly Changes Its Data, but Not Its Views
By Chris Plantier
April 21, 2015
On Friday, April 10, we pointed out that the International Monetary Fund (IMF) apparently had vastly overstated the size and growth of bond fund holdings of emerging market bonds in its latest Global Financial Stability Report (GFSR).
TOPICS: Bond FundBondsEuropeFinancial StabilityFund RegulationICI GlobalInternationalMutual FundTreasury
Federal Reserve Reverse Repo Facility Helps Stabilize Short-Term Money Markets
By Chris Plantier
April 17, 2015
Following a pattern observed at the end of recent quarters, money market fund holdings of European issuers dropped at the end of March, although the decline was not as large as the previous quarter, ending December 2014. As we have noted before, for regulatory reasons European banks have been paring their balance sheets at the end of each quarter, resulting in a temporary decline in their desire to borrow from money market funds.
TOPICS: BondsEuropeFederal ReserveFinancial MarketsFixed IncomeFund RegulationInvestment EducationMoney Market FundsTreasury
The IMF Is Entitled to Its Opinion, but Not to Its Own Facts
By Sean Collins and Chris Plantier
April 10, 2015
On Wednesday, the International Monetary Fund released its latest Global Financial Stability Report (GFSR), including a chapter on the asset management industry and financial stability.
TOPICS: EuropeFinancial StabilityFund RegulationICI GlobalInternationalMutual FundTreasury
European Banks Borrow Less from MMFs; the Federal Reserve Borrows More
By Chris Plantier
January 20, 2015
As we discussed in April and July of last year, due to regulatory pressures European banks generally have become less willing to borrow from U.S. money market funds (MMFs), especially at the end of the quarter. This quarter-end effect was particularly large at the end of December 2014.
TOPICS: EuropeFederal ReserveMoney Market FundsTreasury
The IMF Makes All of OFR’s Mistakes—And More
By Sean Collins and Chris Plantier
October 10, 2014
The International Monetary Fund (IMF) just released its latest Global Financial Stability Report. In the immortal words of Yogi Berra, it is déjà vu all over again.
The IMF report bears more than a passing resemblance to Asset Management and Financial Stability, published by the U.S. Treasury Department’s Office of Financial Research (OFR) in September 2013. The OFR report was met with widespread criticism for its misinformed discussion of hypothetical “vulnerabilities” posed by mutual funds and other asset managers.
TOPICS: EuropeFinancial StabilityFund RegulationICI GlobalInternationalMutual FundTreasury
Why Regulated Funds Are a Relatively Stable Source of Foreign Investment for Emerging Economies
By Chris Plantier
September 26, 2014
The press and policymakers focus a great deal of attention on flows to U.S. and European regulated mutual funds and exchange-traded funds (ETFs), in part because these funds are perhaps the most easily observed and readily measured players in capital markets.
TOPICS: EuropeFinancial MarketsFinancial StabilityFund RegulationICI GlobalInternationalMutual Fund
“Preemptive Runs” and Money Market Fund Gates and Fees: Theory Meets Practice
By Sean Collins and Chris Plantier
August 20, 2014
A recent post on the blog of the Federal Reserve Bank of New York discusses the possibility that new rules by the Securities and Exchange Commission (SEC) allowing money market funds to temporarily impose fees or gates during times of market instability could increase the risk of preemptive runs on such funds during times of stress, rather than helping to limit destabilizing withdrawals, as the SEC intended.
TOPICS: EuropeFederal ReserveFinancial StabilityFund GovernanceFund RegulationGovernment AffairsInternationalMoney Market FundsTreasury
Sizing Up Mutual Fund and ETF Investment in Emerging Markets
By Chris Plantier
August 18, 2014
In coming decades, emerging market (EM) economies will need substantial new capital to accompany and sustain their rapid growth.
TOPICS: Bond FundBondsEquity InvestingEuropeExchange-Traded FundsFinancial MarketsFinancial StabilityFixed IncomeFund RegulationICI GlobalInternationalMutual Fund
European Banks Significantly Reduced Borrowing from U.S. Money Market Funds in June
By Chris Plantier
July 18, 2014
As we discussed in March and April, European banks have generally become less willing to borrow from U.S. money market funds due to regulatory pressures, especially at the end of the quarter. Specifically, the new Basel III requirements seek to increase capital ratios of banks and explicitly limit how much banks fund their operations through short-term borrowing (which includes short-term securities banks issue that money market funds invest in). This quarter-end effect was particularly strong at the end of June as European bank regulators continued to monitor bank progress toward meeting the new Basel III requirements, which will be fully phased in over the next few years.
TOPICS: BondsEuropeFederal ReserveFinancial MarketsFixed IncomeFund RegulationInvestment EducationMoney Market FundsTreasury
Seasonality, U.S. Money Market Funds, and the Borrower of Last Resort
By Chris Plantier
April 16, 2014
The March money market fund holdings data indicate a large drop in the share of fund assets allocated to European counterparties and a large increase in the share of fund assets allocated to U.S. counterparties. This shift is likely temporary and reflects reduced willingness of European banks to borrow from money market funds at the end of the quarter, rather than reduced demand from money market funds. Also, the increase in lending to U.S. counterparties is almost entirely due to the large increase in money market fund lending to the Federal Reserve via its overnight reverse-repo (repurchase agreement) facility.
TOPICS: BondsEuropeFederal ReserveFinancial MarketsFixed IncomeFund RegulationInvestment EducationMoney Market FundsTreasury
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