The Bank of England has published a pilot study into how open-ended funds, dealers and hedge funds would interact in times of stress as concerns increase over a possible liquidity crunch in the bond market.
The study published yesterday, presents “a risk simulation exercise” to test the resilience of liquidity in European corporate bonds where funds come under stress.
It looks at how the combined actions of non-banking firms such as asset managers could cause problems in bond markets if any shocks may arise, such as large redemption requests.
The Bank says the simulation study is not an equivalent of a stress test the Bank regularly conducts on banks on a firm-by-firm basis, when many non-banking firms appear to be safe on an individual basis.
The study attempts to shed a light on how investors behave in challenging market times rather than looking at the safety of individual firms.
It is understood the Bank aims to include insurance companies and pension funds in the scope of its research in future papers.
A ‘spare tire’
Bank financial stability strategy and risk executive director Alex Brazier says the Bank is extending the scope of scrutiny on systemic risks to other financial institutions, as banks are “just half” of Britain’s financial system.
He says: “We stress test banks against deep recession and market crashes so we can make sure that they can carry on lending even if the worst happens. Because they have to pass these stress tests Britain’s banks are now much, in fact, three times stronger. But, what about the rest?
“A big part of that is the bond market where companies borrow to invest by selling bonds to pension funds, insurance companies and asset managers. That market is two thirds bigger than it was 10 years ago. That is a good thing; it has been the spare tire that companies have used while the banking industry was punched by the financial crisis.”
Bank of England financial stability strategy and risk executive director Alex Brazier. Source: Bank of England
What are the Bank’s concerns?
Two main concerns have prompted the Bank to kick off the simulation study: the rapid growth of bond funds and the critical shortage of liquidity in the market in which they trade.
Brazier, who is also a member of the Financial Policy Committee, says: “We are asking what could happen if asset managers find themselves forced to sell bonds into falling markets and what if investment banks and insurance companies have to stop buying.
“What happens in the bond market when there are a lot of sellers and not many buyers? How can that affect the wider economy?”
The Banks estimates assets under management in bond funds have increased by a staggering 80 per cent since 2008, meaning funds now hold a fifth of sterling corporate bonds.
It is also pointed out funds have broadened out from being very equity-focused to being much more fixed income-focused while holding less liquid securities.
From property funds to bonds
Over just the first five months of this year, bond funds have taken over flows in Europe compared to other funds, despite lower interest rates, according to fund data service Lipper.
They have dominated sales in 2014, 2015 and 2016, especially in high yield and corporate bonds. In 2015, they reached a record of £400bn inflows.
The Bank says many funds are still offering daily redemptions at times when they hold illiquid assets, causing a worrying mismatch as seen a year ago with commercial property funds.
In November, Aberdeen Asset Management head of pan-European fixed income Wolfgang Kuhn said he doesn’t rule out the same scenario could happen to bond funds.
He said: “Market participants are aware that central banks will do all it takes to keep things right. It is difficult for market participants to run away in panic. You’ll have more volatility but not difficulty of buying or selling.”
The Bank has already looked at how dealers respond to stresses when levels of capital are low. They tend to be less willing to expand their inventories of securities when other people are selling and hence the price impact of any shock has become much bigger.
The Bank is mainly worried that the capacity of the dealers to buy the assets being sold might run out, leading them to trade at “highly dislocated prices”.
How is the simulation modelled?
Simulating a wave of redemptions, the Banks has looked at three areas:
- Open-ended funds, how they have behaved in the past and how they have changed their prices. The Bank has looked at how these funds sell assets to meet redemptions when they happen (they usually sell a slice of the fund according to Ucits rules, the Bank notes).
- The price impact of those asset sales will have, if dealers are holding inventories and if they can absorb asset sales themselves.
- Investors who tend to behave pro-cyclically and drive prices down and how they respond to that with another wave of redemptions.
The simulation results suggest redemptions from open-ended investment funds can result in “material increases” in spreads in the European corporate bond market, the Bank’s paper says.
It found this risk is now greater than the financial crisis because of the rapid growth of these funds.
In 2008 the European corporate bonds sector saw weekly redemptions of about 1 per cent of assets under management.
The Bank found that if this was increased to just 1.3 per cent, there would be a “breaking point” where dealers reached the limit of their capacity to absorb those asset sales using funds not purchased by hedge funds.
The Bank’s paper says it too early to use these findings for any policy conclusion but said it could in the future inform on a range of macro prudential policies.