Debt De-risking

Focus

We examine how corporate bond fund managers manipulate the risk of their portfolios in response to competitive pressure. How bond funds react to the pressures of competition and investor redemptions is important, given the sector's strong growth over the past few years. Corporate bond funds also matter from the standpoint of financial stability, because the funds allow their shareholders to pull out their money any time, even if the underlying assets are difficult for the asset manager to sell quickly. Market turbulence can ensue if managers are forced to sell off illiquid assets in so-called fire sales.

Contribution

While it is generally agreed how competition influences the risk-taking of equity mutual funds, little is known about its effects on mutual funds that invest in corporate bonds. Yet such funds may be very significant from both a financial stability standpoint and also for the functioning of the real economy, given their role in supplying credit to firms. This paper contributes to the still fairly limited literature on this topic.

Findings

We show that the incentives prevailing in the corporate bond fund sector lead managers of underperforming funds to reduce their risk-taking by investing in safer securities that are easier to sell. They do this mainly by selling cheap (ie higher-yielding) bonds and, at the same time, purchasing more liquid ones with lower yields. This de-risking behaviour is the opposite of what happens in the equity fund sector.

Overall, we argue that the incentive structure of the bond fund industry has some advantages. By de-risking their portfolios, fund managers reduce the risk of investor runs and fire sales for precisely the funds that would be most exposed to such hazards. This could reduce the sector's systemic risk. On the other hand, we find that this market-enforced discipline may be weakened by swing pricing - the practice of passing on to purchasing or redeeming shareholders some of the costs of their trading activity by adjusting the fund's net asset value per share. This may reinstate a moral hazard problem.

Abstract

We examine the incentive of corporate bond fund managers to manipulate portfolio risk in response to competitive pressure. We find that bond funds engage in a reverse fund tournament in which laggard funds actively de-risk their portfolios, trading-off higher yields for more liquid and safer assets. De-risking is stronger for laggard funds that have a more concave sensitivity of flows-to-performance, in periods of market stress, and when bond yields are high. We provide evidence that debt de-risking also reduces ex post liquidation costs by mitigating the investors' incentive to run ex ante. We argue that, in the presence of de-risking behaviors, flexible NAVs (swing pricing) may be counter-productive and induce moral hazard.

JEL classification: G11, G23, G32, E43

Keywords: corporate bond funds, bond market liquidity, asset managers, risk-taking, competitive pressures