The potential impact on the euro area bond market of forced asset sales by euro area investment funds
Published as part of the Financial Stability Review, November 2024.
Structural liquidity mismatches in investment funds might be both a source and an amplifier of systemic risk. Investment funds typically offer more generous redemption terms than the liquidity of their holdings justify. This kind of liquidity transformation might be beneficial to investors and the economy, but can also give rise to financial stability risks.[1] Rapid shifts in investor sentiment in response to negative shocks can lead to large outflows from funds, forcing significant asset sales. This, in turn, can put substantial pressure on asset prices, causing losses to investment funds and other market participants. Rising volatility and related risk management considerations can lead to further outflows, creating asset sale spirals, fuelling contagion and increasing the risk of disorderly corrections.
The factors influencing the price impact of forced asset sales warrant careful consideration. The price impact of forced asset sales is largely dependent on the market footprint of the seller, as illustrated by the liability-driven investment (LDI) crisis and the UK gilt turmoil in September 2022.[2] A large footprint increases the likelihood that a sizeable liquidation of holdings will put additional pressure on their prices. The price impact stemming from outsized supply is also more material if the liquidity of the assets held by the fund is low. Hence, both the size of the funds’ share in individual markets and the liquidity profile of their holdings are critical in gauging the potential financial stability repercussions.
Chart A
Euro area investment funds have a substantially larger footprint in less liquid euro area corporate bonds than in more liquid euro area sovereign bonds
a) Distribution of euro area investment funds’ share in the outstanding amounts for individual bonds, by issuer type | b) Distribution of the average bid-ask spreads for individual bonds held by euro area investment funds, by issuer type |
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(Q2 2022, Q1 2024; percentages) | (Q2 2022, Q1 2024; basis points) |
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Sources: Bloomberg Finance L.P., ECB (SHS, CSDB), S&P Dow Jones Indices LLC and/or its affiliates, MarketAxess (Trax) and ECB calculations.
Notes: Investment funds’ share and average bid-ask spreads are calculated at individual ISIN level. Whiskers denote the 10th and 90th percentiles of the distribution.
The large footprint of investment funds in the euro area corporate bond market makes this segment more vulnerable to disruption. The distribution of the euro area investment funds’ share in the outstanding amounts for individual securities suggests that the sector has a moderate footprint in the euro area sovereign bond market (Chart A, panel a). With a well-diversified investor structure showing differing sensitivity to global and euro area risk events,[3] these bonds appear less susceptible to outflows of specific types of investor. By contrast, investment funds have a much larger footprint in the euro area corporate bond market. In the event of a shock leading to forced asset sales, this market would be more likely to become one-sided. The lack of potential buyers might then result in outsized price adjustments.[4] In addition, euro area corporate bonds held by investment funds are substantially less liquid than sovereign bonds (Chart A, panel b), suggesting that forced sales would have a much bigger impact on prices.
Chart B
Forced sales of less liquid corporate bonds by euro area investment funds are much more likely to result in abnormal price adjustments than is the case for sovereign bonds
a) Estimated price impact of the forced sale of least liquid euro area bonds by euro area investment funds, by outflow size | b) Estimated price impact of the forced sale of least liquid euro area bonds by euro area investment funds, by volatility conditions | c) Estimated price impact of the forced sale of least liquid euro area bonds by euro area investment funds, by liquidation horizon |
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(Q1 2024, basis points) | (Q1 2024, basis points) | (Q1 2024, basis points) |
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Sources: Bloomberg Finance L.P., ECB (SHS, CSDB) and ECB calculations.
Notes: The estimates show an average price impact for the 10% of bond holdings with the lowest Bloomberg Liquidity Score in each issuer segment, proxied by the Bloomberg Liquidity Assessment (LQA) model. The model is based on the empirical observation that market impact is concave on large order sizes. The model leverages pre- and post-trade data by modelling the available volume as a Gamma process, growing in cost and horizon dimensions. The standard deviation of returns shows an average standard deviation for the holdings analysed and the assumed liquidation horizon, based on the Bloomberg LQA Price Volatility. Averages are weighted by the value of the funds’ holdings. Securities are assumed to be liquidated on a pro-rata basis in response to the outflows and leverage ratio assumed to stay constant. NFC stands for non-financial corporations. Panel a: a one-day liquidation horizon and a baseline volatility regime are assumed. Fund outflow is relative to the net asset value (NAV). Panel b: a one-day liquidation horizon and fund outflow of 10% of NAV are assumed. Panel c: the liquidation horizon is expressed in days. A baseline volatility regime and a fund outflow of 10% of NAV are assumed.
A forced asset sale scenario analysis highlights vulnerabilities in the corporate bond space.[5] The price impact of forced asset sales on less liquid corporate bonds could be material in comparison with normal price volatility (proxied by 1 standard deviation of returns), especially in the event of large and sudden redemptions (Chart B, panel a) and during times of high market volatility (Chart B, panel b). This increases the likelihood of second-round effects, as substantial fund losses could induce another wave of redemptions in funds investing in corporate bonds. By contrast, the estimated price impact of euro area investment funds in sovereign bond markets is relatively small, even in the less liquid segments of this market. Importantly, the sensitivity analysis suggests that the adverse price impact resulting from forced asset sales could even be mitigated by small extensions of the liquidation horizon (Chart B, panel c). This underscores the importance of appropriate fund structures, including redemption terms and notice periods for investing in less liquid markets.[6]
Policy adjustments are warranted to better safeguard financial stability. Stress events, where forced asset sales by non-banks have had a significant impact on asset prices, have stimulated a broader discussion on non-banks’ liquidity fragilities. The forced asset sale scenario analysis suggests that regulatory fine-tuning is necessary for funds investing in less liquid assets such as corporate bonds. The extension of notice periods is a liquidity management tool whose use is already envisaged in the EU regulatory framework for investment funds.[7] However, individual asset managers may be hesitant to use the tool because of reputational concerns and stigma effects.[8] Therefore, from a financial stability perspective, additional steps are needed to ensure that minimum notice periods are in place ex ante and that their length aligns with the liquidity profile of fund holdings in both normal and stressed market conditions.
See, for example, Chernenko, S. and Sunderam, A., “Liquidity transformation in asset management: Evidence from the cash holdings of mutual funds”, Working Paper Series, No 23, ESRB, September 2016.
See, for example, the special feature entitled “Stress associated with liability-driven investment strategies”, EU Non-bank Financial Intermediation Risk Monitor 2023, No 8, ESRB, June 2023, and “Risks from leverage: how did a small corner of the pensions industry threaten financial stability?”, speech given by Sarah Breeden at ISDA & AIMA, Bank of England, 7 November 2022.
See, for example, the box entitled “Do global investment funds have a stabilising effect on euro area government bond markets?”, Financial Stability Review, ECB, May 2023.
Similar dynamics were observed during the UK gilt turmoil, where GBP-denominated LDI funds, including those domiciled in the EU, were the key investors in several long-term and inflation-linked bonds subject to forced selling. See also, for example, Dunne, P., Ghiselli, A., Ledoux, F. and McCarthy, B., “Irish-Resident LDI Funds and the 2022 Gilt Market Crisis”, Financial Stability Notes, Vol. 2023, No 7, Central Bank of Ireland, September 2023, and Alexander, P., Fakhoury, R., Horn, T., Panjwani, W. and Roberts-Sklar, M., “Financial stability buy/sell tools: a gilt market case study”, Quarterly Bulletin 2023, Bank of England, November 2023.
Similar results can also be found, for example, in Mirza, H., Moccero, D., Palligkinis, S. and Pancaro, C., “Fire sales by euro area banks and funds: what is their asset price impact?”, Working Paper Series, No 2491, ECB, November 2020, and Lô, S. and Carpantier, J.-F., “Liquidity Stress Test for Luxembourg Investment Funds: the Time to Liquidation Approach”, CSSF Working Paper, CSSF, March 2023.
See, for example, “Revised Policy Recommendations to Address Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds”, FSB, December 2023.
Directive (EU) 2024/927 of the European Parliament and of the Council of 13 March 2024 amending Directives 2011/61/EU and 2009/65/EC as regards delegation arrangements, liquidity risk management, supervisory reporting, the provision of depositary and custody services and loan origination by alternative investment funds (OJ L, 2024/927, 26.3.2024).
See, for example, Morbee, K., “Liquidity management tools in open-ended investment funds: the right tools in the right hands?”, Capital Markets Law Journal, Vol. 18, Issue 2, April 2023, pp. 233-258.