Financial regulation after the global financial crisis of 2007 to 2009 was designed to make banks safer. Owing to tighter regulations intended to safeguard bank balance sheets, called the leverage ratio, part of Basel III reform measures, liquidity provision in corporate bond markets is being shifted to bond mutual funds. According to new research from Southern Methodist University Cox School of Business Professor of Finance and Phyllis Gough Huffington Chair Chotibhak "Pab" Jotikasthira and coauthors, the way in which the bond market functions is being reshaped, with more fragility in the process.
Forthcoming in the "Journal of Finance," the co-authored research examines what happens when banks, long the primary dealers and liquidity providers in bond markets, pull back because of post-crisis capital rules. "Banks act as liquidity providers to many assets, not just bonds," Jotikasthira said. "However, if they withdraw from the market because it becomes expensive for them to make markets in these assets, then other players pick up the slack." Enter the bond mutual fund.
Rise of bond funds
Traditionally, insurance companies, the largest institutional holders of corporate bonds, have held a fairly stable share of the market. Bond mutual funds have grown from roughly 10% to 15% of the market in 2010 to 20% to 25% today, Jotikasthira says. Unlike insurers, which typically buy and hold bonds to maturity to match long-term liabilities, mutual funds trade regularly, tracking indices and chasing alpha for investors. Their growing presence in the market and in trading activity has positioned them to absorb the liquidity-provision role banks are shedding.
In the corporate bond market, banks are the main market makers, acting as a counterparty to investors who wish to buy or sell. The bond market is highly institutional. Today, thanks to the tightened regulation, banks are playing the role of a matchmaker, Jotikasthira offers. Rather than holding a bond in inventory, a bank increasingly just connects a seller to a fund willing to buy at a slight discount. "However, we show in the paper that bond funds are engaging more in liquidity provision now," he said.
A problem arises, according to Jotikasthira, in that mutual funds are structurally different from banks and cannot reliably provide liquidity during times of stress. Banks are funded with insured deposits, which are stable; mutual funds are different. "These bond funds are mostly open-ended," he said. "Which basically means that the investors make redemptions, on a daily basis. But corporate bonds are highly illiquid." When redemptions spike, funds can no longer play liquidity provider.
In the research, the COVID-19 pandemic offered a real-world test of that dynamic. "We show in our paper that during COVID-19, the bonds held by mutual funds with strained liquidity from investor outflows see a much bigger increase in the cost of trading compared to other bonds," Jotikasthira said. Bond funds have clearly benefited from the tighter regulations on banks. “We show that funds with a liquidity-supplying trading style make more money than before, and that profit flows through as alpha to fund investors.”
Change afoot
Jotikasthira offers color about the leverage ratio rule, a blanket capital requirement that ignores riskiness of banks’ holdings. "The leverage ratio rule doesn't care about risk per se," he said. For example, "If you invest $100, you must have $10 in capital, regardless." That penalizes safe assets like Treasuries and investment-grade corporate bonds more than the rule's designers likely intended. He expects regulators in the U.S. and Europe to relax the rule and grant more exemptions for certain bank sizes going forward.
Jotikasthira points to a structural fix already gaining traction in Europe. There, investors who redeem shares absorb the trading costs when they make redemptions. “That change removes the incentive to redeem preemptively — the same dynamic,” he noted, “that drove the run on Silicon Valley Bank. By changing the price at which people could redeem money from mutual funds, that could help to mitigate and limit that sort of strategic run by investors.”
Bond mutual funds will continue to grow, Jotikasthira expects, largely driven by retirement savings flowing into 401(k)s or other vehicles. A realistic path forward isn't shrinking the role of bond funds but redesigning how the liquidity transformation they perform actually works.
The paper, “Intermediary Balance Sheet Constraints, Bond Mutual Funds’ Strategies, and Bond Returns,” is forthcoming in the "Journal of Finance." It is authored by Chotibhak Jotikasthira of the Southern Methodist University Cox School of Business; Mariassunta Giannetti of the Stockholm School of Economics; Andreas Rapp of the Federal Reserve Board of Governors; and Martin Waibel of the Federal Reserve Board of Governors.
Summary written by Jennifer Warren
