Special Report
Highlights Mutual Funds & ETFs: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. BBB Securities: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. Leveraged Loans: The rapid surge in leveraged loans has been partially offset by reduced high-yield issuance, helping mitigate a potentially destabilizing rise in all riskier corporate debt. At the same time, bank exposure is focused on the safest CLO tranches, limiting the potential systemic risks from bank losses. Feature In April, we published a Special Report that investigated whether corporate debt poses a risk to the U.S. economy.1 That report focused on what economic theory and empirical evidence say about the relationship between corporate debt and future economic growth. We arrived at the following conclusions: The empirical evidence decisively shows that private (household + business) debt helps predict future economic outcomes. Some evidence shows that household debt is more important than corporate debt in this regard. In contrast to mainstream economic theory, the level of private debt-to-GDP does not help predict future economic outcomes. Rather, it is rapid private debt growth that is linked to more severe economic downturns. Ebullient credit market sentiment is also shown to predict weak economic growth. Tight credit spreads should be viewed as a warning sign, similar to rapid private debt growth. In this follow-up Special Report, we consider three credit market developments that are unique to this cycle: The large ownership stake of open-ended mutual funds and ETFs in the U.S. corporate bond market. The elevated amount of BBB-rated debt outstanding relative to other credit tiers. The rapid issuance of leveraged loans. All three of these developments could mediate the relationship between corporate debt and economic growth, potentially increasing risks to the economy. We consider each factor in turn. 1. Fund Flows One unique feature of the current cycle is that open-ended mutual funds and ETFs own a much larger share of outstanding corporate bonds than in the past. Back in 1990, insurance companies and pension funds were the largest holders of corporate debt, controlling 54% of the market. Meanwhile, open-ended funds owned a paltry 3%. Since then, fund ownership has surged to 16%, mostly at the expense of financial institutions, insurance companies and pensions. Foreign holdings of U.S. corporate bonds have also increased during this period, from 13% of the market to 28% (Charts 1 & 2). Chart 2Mutual Funds Now An Important Market Player Why Does Fund Ownership Matter? We focus on fund ownership of corporate bonds because it has been theorized that flows into and out of open-ended mutual funds can have a similar impact on market prices as leverage, amplifying price moves in either direction. As described in a 2014 paper by Feroli, Kashyap, Shoenholtz, and Shin:2 [W]hen asset flows for certain fixed income securities are high, prices persistently rise and a feedback loop emerges. High flows lead to rising prices, which attract more flows, which further raises prices. Obviously, the proposed feedback loop also works in reverse: Outflows cause prices to decline, and lower prices lead to further outflows. This sort of feedback loop is unique to mutual funds. Insurance companies and pension funds, for example, do not experience investor capital flight in response to a near-term price drop. This makes the larger presence of mutual funds in the corporate bond market potentially destabilizing. Fund ownership has surged to 16%, from a paltry 3% back in 1990. Why Do Fund Flows Behave This Way? Mutual fund shares are much more liquid than the corporate debt securities they hold. As described in a 2017 paper by Goldstein, Jiang and Ng:3 When [mutual] fund investors redeem their shares, they get the net asset value as of the day of redemption. The fund then has to conduct costly liquidation that hurts the value of the shares for investors who keep their money in the fund. Hence, the expected redemption by some investors increases the incentives for others to redeem. In other words, during times of stress, mutual fund investors have an incentive to withdraw their money before other fund shareholders get the chance. Otherwise, they could be stuck holding a basket of illiquid corporate bonds. This bank-run like behavior is well documented for corporate and municipal bond funds, though it appears not to exist for funds that traffic in more liquid instruments, such as Treasuries and equities. In fact, when Goldstein et al looked at how flows into and out of individual corporate bond and equity funds respond to past fund performance, they found that the Flow-Performance curve for an individual corporate bond fund exhibits a pronounced concave shape. Meanwhile, the same curve for an individual equity fund is convex (Chart 3). This means that corporate bond mutual fund shareholders are quick to redeem their shares in response to poor fund performance, while equity fund shareholders are more inclined to stand pat. On the flipside, positive fund performance leads to large equity fund inflows, but doesn’t attract capital to corporate bond funds to the same extent. The above results apply to individual funds, but Goldstein et al also performed the same analysis for corporate bond funds in the aggregate. That is, rather than measuring whether investors sold a particular corporate bond mutual fund in response to its poor performance, they measured whether investors exited the corporate bond mutual fund space altogether in response to poor corporate bond performance. Interestingly, they found a very similar result (Chart 4). Investors are inclined to exit the corporate bond space entirely following periods of poor performance. Meanwhile, they found no relationship between aggregate equity fund flows and performance. Investors might switch between different equity funds in response to recent performance trends, but they don’t exit the asset class altogether. These results provide a clear indication for why the large presence of corporate bond mutual funds might be destabilizing. Corporate bond fund investors are quick to flee the space during periods of poor performance. For more liquid securities, such as equities and Treasuries, a large mutual fund presence in the market is not a concern, since flows do not respond as aggressively to price shocks. Empirical Evidence For The Flow-Performance Feedback Loop The evidence presented above shows that fund flows respond to performance, but for the theorized feedback loop between fund flows and corporate bond prices to exist, we also need evidence that fund flows impact corporate bond performance. In that regard, a 2019 Banque de France working paper examines the impact of aggregate flows into French corporate bond funds on the yields of the underlying securities.4 It finds that not only do flows impact yields contemporaneously, but also that outflows have a larger influence on yields than inflows. Using a different methodology, a 2015 paper by Hoseinzade finds no material impact of fund flows on underlying corporate bond yields, but for an interesting reason.5 The paper confirms that corporate bond fund shareholders demonstrate bank-run like behavior in response to poor performance, but also argues that “bond fund managers hold a significant level of liquid assets, allowing them to manage redemptions without excessively liquidating corporate bonds.” Chart 5Funds Deploy Cash Before Selling Bonds It’s true that corporate bond mutual funds often hold significant allocations to cash and U.S. Treasuries, and Hoseinzade shows that fund managers tend to discharge their most liquid holdings first, before attempting to sell corporate bonds. This result lines up with our casual observation. Chart 5 shows the aggregate liquid asset (cash and Treasury) holdings of corporate bond mutual funds. It is apparent that they tend to fall during periods of spread widening. We also note that corporate bond mutual funds, in aggregate, currently hold about 6% of their assets in liquid securities. This buffer can probably withstand a sizeable shock, but liquid assets fell from similar levels into negative territory during each of the past two recessions. One other factor that could help break the feedback loop between fund flows and prices is the institutional ownership of corporate bond mutual funds. Goldstein et al find that mutual funds mostly owned by institutional investors exhibit less of a feedback loop between flows and performance. That is, large institutional investors are less likely to redeem their shares in response to a bout of poor performance. While we don’t have data on corporate bond mutual fund ownership specifically, Federal Reserve data reveal that insurance companies and pension funds own a significantly larger proportion of outstanding mutual fund shares than in the 1990s, though less than they did in the mid-2000s (Chart 6). Note that Chart 6 shows data for all mutual funds, including equity funds, Treasury funds, etc… Chart 6Institutional Ownership Of Mutual Funds We conclude that there is enough evidence of a feedback loop between fund flows and corporate bond prices that we should be wary of the growing presence of open-ended mutual funds and ETFs in the corporate bond space. Cash holdings and institutional ownership can help mitigate negative flow/performance feedback loops to some extent, but probably shouldn’t be counted on in the event of a severe shock. What’s The Economic Impact? In our corporate debt Special Report from April, we postulated that changes in corporate bond spreads might, themselves, cause an economic downturn, rather than simply reflect one. The mechanism is summarized nicely by Lopez-Salido, Stein and Zakrajsek (2016):6 [a] sentiment-driven widening of credit spreads amounts to a reduction in the supply of credit, especially to lower credit-quality firms. It is this reduction in credit supply that exerts a negative influence on economic activity. With that in mind, in the current environment it seems very possible that an initially sentiment-driven credit spread widening could be exacerbated by outflows from corporate bond mutual funds. A larger shock to credit spreads leads to a larger reduction in credit supply and a more severe economic impact. Aggregate liquid asset holdings of corporate bond mutual funds tend to fall during periods of spread widening. Bottom Line: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. 2: BBB Debt Outstanding Chart 7The Large Amount Of BBB Debt It has been widely reported that an unusually large amount of outstanding corporate bonds are rated BBB, the lowest credit rating that is still considered investment grade. In fact, the par value of BBB-rated securities now makes up 50% of the Bloomberg Barclays Investment Grade index, up from 21% in 1990 (Chart 7). The amount of outstanding BBB securities is more than double the par value of the Bloomberg Barclays High-Yield index, and BBBs represent 41% of the total combined par value of the investment grade and high-yield indexes. The reason to be wary about the large amount of outstanding BBB debt is that when the credit cycle turns and ratings downgrades start to occur, a larger than normal amount of debt will be downgraded from investment grade into high-yield. When that happens, any investors with an investment grade-only mandate will be forced to sell. The concern is that such forced selling could set off a negative feedback loop very similar to the one discussed in the first section. An added layer of risk comes from the fact that in addition to investment grade-only mutual funds, insurance companies and pension funds – who still control 35% of the corporate bond market (see Chart 2 on page 3) – are often burdened with larger capital costs for high-yield debt. This means that a very large pool of investors could be impacted by a spate of BBB downgrades. In terms of the potential market impact, a 2010 paper by Ellul, Jotikasthira and Lundblad investigated fire sales of downgraded corporate bonds induced by regulatory constraints.7 The authors found that insurance companies often engage in the forced selling of bonds that have been recently downgraded into high-yield. Further, the downgraded bonds experience negative near-term price pressure from the fire sale, but that pressure tends to reverse after a few months. The finding that the negative price pressure is fleeting is important. In contrast to the negative feedback loop that can be generated by mutual fund flows, BBB securities can only be downgraded to high-yield once. In other words, once the initial fire sale of fallen angel debt takes place, there is no mechanism to force the downward price pressure to continue.8 Bottom Line: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. 3. Leveraged Loans The rapid growth of leveraged loans – lending made to below investment-grade borrowers - over the past couple of years has caught the attention of global central banks and financial regulators. That concern is understandable, as it would be a dereliction of duty for any policymaker or regulator who lived through the 2008 financial crisis to not consider the potential risks to financial stability and future economic growth from a surge in lower quality lending. This is especially true given the increase in the number of securitized instruments linked to leveraged loans – collateralized loan obligations, or CLOs – which evokes memories of the toxic subprime mortgage products that helped trigger the 2008 crisis. Although as the Fed’s Vice Chair for Supervision, Randal Quarles, recently noted, the financial media has been overplaying the leveraged loan story in such a way that it felt like “the Earth must be getting hit by an asteroid.” The BoE estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. The leveraged loan and CLO markets can be opaque. However, based on the information we do have from credible sources like central banks, the IMF and the BIS, some conclusions can be made about the potential economic risks from the rapid build-up of U.S. leveraged loans: Leveraged loan expansion has been partially offset by high-yield contraction. Chart 8More Leveraged Loans, Less Junk Bonds Based on estimates from the BIS and IMF, there are around $1.4 trillion in U.S. leveraged loans outstanding, which is greater than the $1.2 trillion U.S. high-yield bond market (Chart 8). That is an all-time high in the dollar amount of leveraged loans, as well as for the share of all lower-rated corporate debt accounted for by loans. The annual growth rate of U.S. leveraged loans is now a whopping 29% - the fastest pace seen since 2007. Yet the growth of the total amount of leveraged loans plus high-yield bonds is a much lower 12%. While that is still a large number, it is below the peak growth rates seen during the past fifteen years. This is because the amount of high-yield bonds outstanding has been modestly contracting since 2015. Much of that run-up in leveraged loan growth has been to satiate the demand for loans created by private equity funds and, more importantly, CLOs. The strong risk appetite from investors resulted in a notable deterioration in lending standards, with loans coming out at higher leverage multiples (debt/EBITDA) and with reduced investor covenant protection. Yet since lower-rated companies were not ramping up high-yield bond issuance at the same time, the economic stability risks from a rapid run-up in total riskier borrowing are lower, on the margin. The ownership structure of leveraged loans (and CLOs) is diverse enough to not create systemic problems. To date, the Bank of England (BoE) has compiled the most detailed estimates of the ownership breakdown of both leveraged loans and CLOs.9 In Chart 9, we have recreated a chart from the BoE’s July 2019 Financial Stability Report, which colorfully shows the ownership of global leveraged loans and CLOs. The way to read the chart is that each square represents a 1% share of the estimated $3.2 trillion of global leveraged loans and CLOs. The split in the chart is 75% loans and 25% CLOs (CLO ownership is shown on the right side of the thick dotted line). The biggest category of leveraged loan investor is what the BoE titled “U.S. and other global banks”, a group that represents 38% of total loans and CLOs. European banks own 12%, U.K. banks own 3% and Japanese banks own 3% (entirely through CLOs), thus bringing the global bank exposure to 56% of all leveraged loan instruments. While that sounds like a large number, the majority of that is in the form of revolving credit facilities – effectively, overdraft facilities to lower-rated borrowers. Revolving credit facilities are typically less risky than leveraged loans, because credit facilities have greater covenant protection and even more seniority in terms of creditor claims on borrower assets. The BoE estimates that 40% of all global leveraged loans and CLOs are owned by non-bank investors. This includes pension funds, insurance companies and investment funds (mutual funds and ETFs). Chart 9 shows how much more diverse the investor base is for CLOs than for other leveraged loans. It suggests that any future potential losses from CLOs will be distributed more evenly within the financial system, rather than being concentrated in the banks. Chart 10Leveraged Loan Losses Are Typically Lowered Compared To Junk Even within the bank holdings of CLOs, the systemic risks are lessened. The BoE noted that the increased amount of subordination (i.e. lower-rated tranches) of more recent CLO deals helps protect the senior tranches from losses. According to the BoE, the AAA-rated piece of a representative sample of CLOs issued in 2018 was 63%; this compares to 70% for CLOs issued in 2006.10 Furthermore, the central bank estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. That would be an extraordinary outcome, given how 2008 generated losses on leveraged loans that were over twice as bad as the previous worst year in 2002 (Chart 10). Potential losses from AAA tranches are important from a financial stability perspective. The BoE estimates that 40% of all CLOs are owned by global banks (including a large 13% share from yield-chasing Japanese banks). These banks tend to focus on safer AAA-rated CLO tranches. The demand for leveraged loan products is volatile, but that might actually be a good thing for economic stability. The surge in leveraged loans over the past two years has not only been related to demand from private equity funds and CLOs. U.S. retail investors have also been big buyers of mutual funds and ETFs linked to the leveraged loan market, as a way to seek out higher credit returns against a backdrop of Fed rate hikes. Chart 11Fed Rate Expectations Drive The Demand For Loans Vs Bonds Leveraged loans are floating rate instruments. Thus, they are more desirable than fixed-rate high-yield corporate debt when short-term interest rates are rising. This is seen in Chart 11, where we show net flows into the largest U.S. junk bond and leveraged loan ETFs. These flows are plotted with the JP Morgan survey of bond investor duration positioning (top panel) and our Fed Funds Discounter that measures the market-implied expected change in the fed funds rate over the next year (bottom panel). The conclusion is obvious – there was very strong retail demand for floating-rate leveraged loans over fixed-rate junk bonds during 2016-18 when expected rate hikes justified defensive duration positioning. In 2019, the tables have turned. The Fed is more dovish, rate cuts are now expected, investors have been adding duration exposure, and demand for leveraged loan funds has plunged while high-yield bond funds have been seeing inflows. The exodus from all leveraged loan funds has been historically large, with Lipper reporting that there were 33 straight weeks of outflows to July 3, 2019, for a total of $32 billion.11 Already, that reduced demand for leveraged loans has translated into sharply reduced issuance of new U.S. CLOs, which was 73% lower in the first half of 2019 versus the same period in 2018 (Chart 12). At the same time, high-yield bond issuance was up 20% in the first six months of 2019 versus 2018. The reduced demand for leveraged loans has also shifted the balance of power back to lenders, as the share of U.S. leveraged loans that have been issued with limited covenant protection (“cov-lite”) has plunged from 72% in 2018 to around 40% (Chart 13). Chart 12Lower-Rated Issuance Is "Self-Regulating" Chart 13Reduced Covenant-Lite Issuance So Far In 2019 This is a critical point on the potential stability risks from leveraged loans – the market for those loans is “self-regulating”, based on final demand from investors who “toggle” between floating rate and fixed rate credit instruments. This helps limit the growth in overall corporate indebtedness, helping to put off the date when credit booms turn into future credit busts. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 2 https://www.nowpublishers.com/article/DownloadEBook/9781680834864?format=pdf 3 http://finance.wharton.upenn.edu/~itayg/Files/bondfunds-published.pdf 4 https://ideas.repec.org/p/bfr/banfra/706.html 5 https://pdfs.semanticscholar.org/5a60feab84a7d10de084abfce414b5888d5586e2.pdf 6 https://www.nber.org/papers/w21879 7 https://pdfs.semanticscholar.org/55a4/8602b17bc7e7f8428695ab6a3ef2c87756ab.pdf 8 Corporate bonds that are downgraded from investment grade to high-yield are called fallen angels. 9 The Financial Stability Board, the international body that monitors and makes recommendations on the global financial system, is due to publish a comprehensive analysis of the ownership structure of the leveraged loan market in the autumn of 2019. 10 For a more detailed description of this analysis, see pages 28 & 29 of the Bank of England’s July 2019 Financial Stability report, which can be found here: https://www.bankofengland.co.uk/financial-stability-report/2019/july-20… 11 https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/leveraged-loan-news/leveraged-loan-fund-withdrawal-streak-hits-record-33-weeks-totaling-32b
