Bond fund cash hoarding is ‘the rule, rather than the exception’ during times of stress and the asset sales needed to fund this were a ‘destabilising’ factor in an overwhelming majority of recent sell-offs, according to a large analysis of portfolio data by Bank for International Settlement (BIS) researchers.
The paper, published last week by BIS economists Stephen Morris, Ilhyock Shim and Hyun Song Shin, warned that for every $100 of redemptions during periods of sustained portfolio outflows, managers were selling an average $110 of assets, ending rather than beginning each crisis with excess cash.
The self-reinforcing nature of fire sales mean portfolio bond holdings were more likely to be pro- than anti-cyclical components of market sell-offs, the researchers suggested.
‘Discretionary sales of the underlying asset tend to reinforce investor redemption-driven sales,’ they noted. ‘The corollary is that mutual fund holding of cash is actually increasing in the incidence of investor redemptions.
‘We [also] find evidence of asymmetry between discretionary purchases and discretionary sales. The positive relationship between investor-driven sales and discretionary sales is stronger than the corresponding relationship between investor-driven purchases and discretionary purchases.’
The study is the latest instalment in BIS’ ongoing research series into bond market liquidity, which has previously identified the growing concentration risks in the dominance of a handful of market-dominating mandates and increased market volatility resulting from the decline of market-making.
But the report is the first to look at how asset managers themselves are incentivised to prepare for and deal with volatility, and how their actions interact with other managers and market momentum.
‘Our understanding of crisis propagation is heavily influenced by the experience of the 2008 crisis. Banks have been the focus of attention, and the watchwords have been leverage, maturity mismatch, complexity and insolvency.
‘Discussions of financial stability have also revolved around market liquidity, and actions of asset managers in the face of redemptions by ultimate investors. The concern has been with evaporating market liquidity and one-sided markets in the face of concerted investor redemptions.’
They added: ‘Our paper is concerned with a third dimension to the debate, to do with liquidity management by asset managers in their interactions with ultimate investors. If asset managers use their cash holdings as a buffer to meet investor redemptions, they can deal with redemptions without resorting to the sale of the underlying assets.’
The analysis considered the 2,040 bond funds which reported data into flows analyst EPFR Global’s database between January 2013 and June 2016, of which 1,400 invested in developed market and 640 in emerging market (EM) issues, and included only open-ended, actively managed mandates.
Manager responses to sustained, general sector outflows were categorised in one of two buckets: a ‘pecking order’ approach, in which unit sales were funded from cash first and assets second, and a ‘hoarding’ approach, in which cash buffers were held broadly constant, funded by asset sales.
The researchers found a strong, positive relationship between redemptions and cash hoarding; while broad-based, the relationship was unsurprisingly found to be strongest in lower-liquidity EM markets and weakest in highly-tradable US sovereign funds. In the most liquid markets, funds recorded an average $103 in sales for every $100 in outflows.
While the relationship held up when the market went down, it was much weaker on the way back up, with a relationship between investor purchases and asset buying only visible in EM mandates.
Before we beat up on asset managers too hard, the research also turned up evidence of quite pronounced herding on behalf of fund buyers. Asset managers are at risk of being punished on the overall direction of their peer group rather than on the strengths or weaknesses of their security selection and asset allocation, which clearly incentivises them to stay ahead of the curve.
‘Bond fund [investors] exhibit strong directional co-movement in their choice of investment into or redemptions from funds,’ the researchers noted. ‘Investors in global EM bond funds, especially those in global EM local currency government bond funds and global EM corporate bond funds, simultaneously commit or redeem funds more often than those in global DM bond funds.
‘Investors tend to abruptly switch from inflow-side clustering to outflow-side clustering, and often continue to redeem heavily for a few or several consecutive months before they switch to relatively more inflows than outflows.
‘Such evidence supports [our] model’s prediction that mutual fund investors tend to alternate between two states: in one state, all investors commit new funds; and in the other state, they all redeem. Also, the clustering analysis shows that the more illiquid the underlying bonds are, the more likely to see stronger clustering of investor flows across funds investing in the same asset class.’
The finding is likely to be particularly relevant to EM funds, which are likely to be predominantly held via portfolio ownership.