Mutual Fund Liquidity Transformation and Reverse Flight to Liquidity
Yiming Ma Columbia GSB
Kairong Xiao Columbia GSB
Yao Zeng Wharton
2020 Financial Stability Conference November 2020
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 1 Motivation
I Covid-19 crisis: traditionally liquid assets became strained from unusually high selling pressures I e.g. Haddad, Moreira, and Muir 20; Du e 20; He, Nagel, and Song 20; Kargar et al. 20
I Reverse ight to liquidity
I Conventional wisdom: ight to liquidity during market distress I high buying pressure for liquid assets
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 2 Heightened Selling Pressure in Treasury Market .1 0 -.1 -.2 -.3 -.4 US Treasury CDS-adjusted adjusted swap spreads (%) Jan Feb Mar Apr May
Treasury discount ↓ = Interest swap yield + Treasury CDS - Treasury yield ↑
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 3 Motivation
I The conventional negative correlation between Treasury yield and VIX is reversed in Covid-19 crisis Figure: Treasury Yields and VIX in Jan-Apr 2020 2.5 01-09 01-0201-08 01-1701-1301-07 01-1601-1401-1001-0601-03 01-1501-2101-22 01-23 01-2402-05 02-0601-28 02-1202-1302-04 02-1402-1002-1102-0701-3001-2901-27
2 02-1902-1802-03 02-2001-31 02-21 02-24 02-2602-25 02-27 03-1903-18
03-0403-02 03-0302-28 03-17 03-05 03-13 03-20 03-12 1.5 03-25 03-26 04-1404-13 03-24 30-year Treasury yield (%) 04-0904-08 03-31 04-07 03-23 03-16 03-1103-30 03-27 04-3004-1704-1504-0603-1004-02 04-01 04-2904-27 03-0604-2004-03 04-28 04-1604-22 04-24 04-2304-21
1 03-09 20 40 60 80 VIX
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 4 Motivation
I Conventional wisdom: ight to liquidity Figure: Treasury Yields and VIX in Aug-Sep 2008 4.8
08-06 08-05 08-11 4.6 08-1308-0108-04 08-0808-0708-12 08-14
08-2208-1508-2108-19 08-2008-2908-18 09-23 08-2608-25 09-2509-2209-24 4.4 08-2808-27 09-02 09-19 09-26 09-03 09-12 09-30 09-0809-0509-04 09-10
30-year Treasury yield (%) 09-1109-09 4.2 09-18 09-15 09-29 09-16 09-17 4 20 30 40 50 VIX
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 5 Heightened Selling Pressure in IG Corp Bonds 0 -1 -2 CDS-bond basis (%) -3 -4 Jan Feb Mar Apr May
IG HY
CDS-bond basis ↓ = corporate bond CDS spread ↑ - corporate bond spread ↑↑↑
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 6 Motivation
The market for U.S. Treasuries has long been viewed as the world's most liquid nancial market. That presumption was questioned...
Still the World's Safe Haven? Darrel Du e
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 7 I With more liquidity transformation by bond funds I Liquid assets may experience more volatility I May steer central banks towards providing liquidity backstops to bond funds
I Implications of the reverse ight to liquidity phenomenon
What caused the reverse ight to liquidity phenomenon?
I Bond mutual funds I Liquidity transformation → large redemption in crisis I Pecking order of liquidation → concentrated sale of liquid assets
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 8 What caused the reverse ight to liquidity phenomenon?
I Bond mutual funds I Liquidity transformation → large redemption in crisis I Pecking order of liquidation → concentrated sale of liquid assets I Implications of the reverse ight to liquidity phenomenon I With more liquidity transformation by bond funds I Liquid assets may experience more volatility I May steer central banks towards providing liquidity backstops to bond funds
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 8 Literature 1. Disruptions in liquid asset market during Covid-19 I Haddad, Moreira, and Muir 20 and Kargar et al. 20: document debt market disruptions I Du e 20, He, Nagel, and Song 20: dealer constraints I Falato, Goldstein and Hortacsu 20: fragility in fund ows I A new explanation for heightened selling pressure in liquid assets through mutual fund liquidity transformation 2. Financial intermediation by banks versus non-banks I E.g. Diamond and Dybvig 83, Goldstein and Pozner 05, Hanson, Shleifer, Stein, and Vishny 15, Ma, Xiao, and Zeng 20 I Asset-side implications of liquidity provision by mutual funds versus banks 3. Mutual fund ows and nancial stability I E.g. Chen, Goldstein, and Jiang 10, Goldstein, Jiang, and Ng 17, Chernenko and Sunderam 17, Jiang, Li, and Wang 20 I ↑ fund asset illiquidity → ↑ potential for liquid asset market disruptions
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 9 Roadmap
1. Aggregate Trends 2. Empirical Evidence
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 10 Bond Fund Growth
I Bond mutual funds have become increasingly important... Total Assets Fund Shares/Deposits 5000 .35 4000 .3 3000 .25 2000 Fund assets (billion) .2 1000 Fixed-income fund shares / Bank deposits 0 .15 1995 2000 2005 2010 2015 2020 1995 2000 2005 2010 2015 2020
I AUM: $1 trillion to $4.5 trillion from 2007 to 2019 I Shares/Deposits: 0.22 to 0.35 from 2007 to 2019
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 11 Bond funds
Liquid assets Demandable equity Illiquid assets
I Like banks, bond funds provide liquidity by issuing liquid claims backed by (mostly) illiquid assets I Liquidity transformation may lead to rst-mover advantage, e.g. Market value drops from 100 to 80 but NAV is still at 90
Mutual Fund Liquidity Transformation
Bank
Liquid assets Demandable debt Illiquid assets
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 12 I Like banks, bond funds provide liquidity by issuing liquid claims backed by (mostly) illiquid assets I Liquidity transformation may lead to rst-mover advantage, e.g. Market value drops from 100 to 80 but NAV is still at 90
Mutual Fund Liquidity Transformation
Bank Bond funds
Liquid assets Liquid assets Demandable debt Demandable equity Illiquid assets Illiquid assets
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 12 Mutual Fund Liquidity Transformation
Bank Bond funds
Liquid assets Liquid assets Demandable debt Demandable equity Illiquid assets Illiquid assets
I Like banks, bond funds provide liquidity by issuing liquid claims backed by (mostly) illiquid assets I Liquidity transformation may lead to rst-mover advantage, e.g. Market value drops from 100 to 80 but NAV is still at 90
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 12 Pronounced Out ows at Bond Funds
I Bond funds suered an unprecedented $264 billion out ows in March, 2020
Bond funds Equity funds 100 100 0 0 -100 -100 Fund flows (billion) Fund flows (billion) -200 -200 -300 -300 2000 2005 2010 2015 2020 2000 2005 2010 2015 2020
I Equity funds suered much smaller out ows → liquidity transformation must matter...
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 13 Higher Asset Illiquidity, Larger Out ows
I ...also evident from more pronounced out ows at more illiquid bond funds 10 0 -10 Cummulative fund flows (% AUM) -20 Jan2020 Feb2020 Mar2020 Apr2020 May2020
Government Investment grade High yield Loan
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 14 Concentrated Sales of Liquid Assets
I Liquid assets were disproportionately liquidated 0 -5 Position change (%) -10 B A B- A- B+ A+ BB AA BB- AA- BB+ AA+ BBB AAA CCC BBB- CCC- BBB+ CCC+ Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 15 Large Aggregate Liquidations I Aggregate Treasury liquidations by open-end funds amounted to $236 billion in 2020Q1 Rest of the world Mutual funds Households Broker dealers Foreign banking offices in U.S. Pension funds Credit unions ABS Closed-end funds Banks GSEs Nonfinancial business Insurance companies ETFs Money market funds -300 -100 100 300 Change in Treasuries (billion) Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 16 Empirical Evidence Liquidity Transformation and Out ows: Fund-level Evidence Figure: Fund Out ows versus Fund Liquidity Provision Index (LPI) 6 4 2 Fund outflows 0 0 2 4 6 8 Liquidity Provision Index (LPI) I LPI = per dollar expected contract payment - direct liquidation value assets (Ma, Xiao and Zeng 19) Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 17 Cross-section Determinants of Out ows I High asset illiquidity → more out ows (1) (2) (3) (4) Out ow Out ow Out ow Out ow Fund illiquidity 0.546∗∗∗ 0.545∗∗∗ 0.537∗∗∗ 0.564∗∗∗ [0.092] [0.092] [0.094] [0.096] Institutional 0.137 0.135 0.283 [0.203] [0.203] [0.204] Index fund -0.259 -0.614 [0.595] [0.602] Fund objective F.E. No No No Yes Observations 6,355 6,355 6,355 6,355 Adj. R-squared 0.005 0.005 0.005 0.021 I Other controls: yield, return volatility, expense ratio, turnover ratio Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 18 What did funds sell when they face redemption? Reverse Flight to Liquidity: Pecking Order Liquidations Fund Out ow i,j = β j + γXi + θXj + i,j Figure: Liquidation to Redemption Sensitivity by Bond Rating 2 1.5 1 .5 0 -.5 B A B- A- B+ A+ BB AA BB- AA- BB+ AA+ BBB AAA CCC BBB- CCC- BBB+ CCC+ Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 19 Pecking Order based on Relative Liquidity: Measure Rank X Share 1 Liquidity Liquidity i,j = i0,j × [ i > i0 ] i0 I Ranki,j is de ned as the sum of shares of assets held by fund j that are less liquid than bond i Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 20 Pecking Order based on Relative Liquidity: An Example I Compare two identical Treasury bonds held by (1) a Treasury fund and (2) a corporate bond fund I Treasury bond fund has more liquid assets → ranked lower in the pecking order I Corporate bond fund has more illiquid assets → ranked higher in the pecking order I Corporate bond fund is more likely to sell the Treasury bond for the same redemption Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 21 Reverse Flight to Liquidity: Pecking Order Liquidation Out ows Rank i,j = β j × i,j + γXi,j + i,j (1) (2) (3) Open-end Open-end Open-end All Active Passive Out ows 0.268∗∗∗ 0.208∗∗∗ 0.224∗∗∗ [0.016] [0.024] [0.035] Out ows*Rank 0.198∗∗∗ 0.386∗∗∗ 0.082 [0.047] [0.060] [0.151] Bond F.E. Yes Yes Yes Fund objective F.E. Yes Yes Yes Observations 79,050 37,945 39,410 Adj. R-squared 0.067 0.071 0.050 Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 22 Did funds' selling pressure aect prices of liquid assets? Bond yields by liquidation rank Figure: Pecking order of liquidation and bond yield 40 20 0 Yield (bps) -20 -40 Feb Mar Apr May Q1 Q2 Q3 Q4 Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 23 Impact on Asset Prices Holding Imputed Out ow X Fund out ow i,j,2019Q4 i,t = j,t × P Holding j k i,k,2019Q4 Return Imputed Out ow High rank i,t = β i,t × i + γXi,t + i,t (1) (2) (3) Return Return Return Out ows -1.646 -1.741 -1.856 [1.167] [1.174] [1.194] Out ows*High rank -3.443∗∗ -3.550∗∗ -3.506∗∗ [1.426] [1.433] [1.459] Rating-Time F.E. Yes No No Maturity-Time F.E. Yes No No Issuer F.E. No Yes Yes Bond F.E. No No Yes Observations 398,678 398,678 398,677 Adj. R-squared 0.174 0.175 0.166 Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 24 What were the eects of Fed interventions ? Fed Intervention Unprecedented intervention by the Fed in xed income markets: I March 15: Announced purchase of Treasuries I March 23: Announced purchase of IG corporate bonds I April 9: Announced extension of corporate bond purchase I Larger volume I Include fallen angels Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 25 Eect of Fed Interventions on Fund Flows Outflowsi,t = βF edInterventiont + γXi,t + i,t (1) (2) (3) (4) Govt IG HY BL Treasury bond purchase 0.014 0.043 0.093∗∗∗ 0.093∗∗∗ [0.032] [0.039] [0.026] [0.033] Corp bond purchase 0.217∗∗∗ 0.366∗∗∗ -0.057 0.161∗∗∗ [0.040] [0.063] [0.035] [0.051] Corp bond purchase expansion 0.057∗∗∗ -0.039∗∗ -0.069∗∗∗ -0.073∗∗∗ [0.017] [0.019] [0.008] [0.010] Control Yes Yes Yes Yes Fund xed eects Yes Yes Yes Yes Month xed eects Yes Yes Yes Yes Observations 13,573 6,452 17,819 9,364 Adj. R-squared 0.058 0.071 0.067 0.096 I Announcements of corp bond purchase stopped out ows, but Treasury bond purchase did not Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 26 Eect of Fed Interventions on Fund NAV ∆NAVi,t = βF edInterventiont + γXi,t + i,t (1) (2) (3) (4) Govt IG HY BL Treasury bond purchase 0.241∗∗ 0.188 -2.336∗∗∗ -2.618∗∗∗ [0.119] [0.236] [0.274] [0.290] Corp bond purchase 0.901∗∗∗ 0.866∗∗ -1.261∗∗ -1.941∗∗∗ [0.178] [0.400] [0.486] [0.487] Corp bond purchase expansion 0.399∗∗∗ 1.616∗∗∗ 1.621∗∗∗ 1.114∗∗∗ [0.039] [0.066] [0.111] [0.095] Control Yes Yes Yes Yes Fund xed eects Yes Yes Yes Yes Month xed eects Yes Yes Yes Yes Observations 13,565 6,451 17,816 9,357 Adj. R-squared 0.180 0.427 0.323 0.377 I Announcements of corp bond purchase increased NAVs, but Treasury bond purchase did not Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 27 Why did reverse ight to liquidity emerge this time? I Increased liquidity transformation by funds since last crisis I Bond fund AUM: $1 trillion to $4.5 trillion from 2007 to 2019 I With increased mutual fund liquidity transformation, going forward: I Increased volatility in traditionally liquid assets I "Are US Treasury Bonds Still a Safe Haven?" (He and Krishnamurthy, 2020) I Mutual funds conduct liquidity transformation outside public liquidity backstops I More reliance on unconventional central bank asset purchases Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 28 Conclusion 1. What caused the reverse ight to liquidity phenomenon? Mutual funds transform liquidity by issuing demandable equity shares + using pecking order of liquidations 2. What are the policy eects? The purchase of illiquid assets directly alleviates fund out ows and is more eective than the purchase of liquid assets 3. What was special about the Covid-19 crisis? Could everything happen again in the future? Migration of liquidity transformation to mutual funds Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 29