Did Canadian Corporate Bond Funds Increase their Exposures to Risks?

Introduction

Canadian fixed-income mutual funds have grown rapidly over the past 10 years—15 per cent annually compared with 2.6 per cent for equity funds. These investment vehicles direct a growing share of funds from savers to borrowers and now are a large component of the Canadian shadow banking sector (Young Chang et al. 2016). This note focuses on open-ended mutual funds with large holdings of Canadian corporate bonds, a subset of Canadian fixed-income mutual funds.

Canadian corporate bond mutual funds (CCBFs) are more vulnerable than other funds because of the liquidity mismatch between their assets and liabilities: the funds offer daily redemption to investors yet they invest in relatively less-liquid assets (corporate bonds). This mismatch raises concerns that CCBFs may face large redemption requests during periods of stress (Goldstein, Jiang and Ng 2017). Indeed, in 2017, the Financial Stability Board issued policy recommendations to reduce this vulnerability (FSB 2017).

In this note, we first document the growth of CCBFs in number and size over the past decade. Second, we assess the risks in their portfolios—credit risk, interest rate risk and liquidity risk. We find that CCBFs have more than doubled in size and number in the last decade. We also find that, on average, CCBFs have increased their allocation to (i) corporate bonds, (ii) bonds with lower credit ratings, and (iii) bonds with longer duration. At the same time, CCBFs have reduced their allocation to cash and other liquid assets.

We offer potential explanations for this change in portfolio allocation. We also explore how these findings suggest an increase in the likelihood of large investor redemptions and with higher potential impact on the Canadian fixed-income market. But CCBFs still hold, on average, cash and liquid assets equivalent to the worst outflows observed since 2007. Overall, the vulnerability of CCBFs for the Canadian financial system appears to be rising—which warrants close monitoring—but remains low. The United States, euro area and other jurisdictions raised similar implications (ECB 2017; OFR 2016; BoE 2016; and IMF 2015).

Canadian corporate bond mutual funds

By our definition, CCBFs are open-ended mutual funds with large holdings of Canadian corporate bonds denominated in Canadian dollars. Specifically, CCBFs meet these criteria:

• Each CCBF holds at least 25 per cent of the fund’s portfolio in Canadian corporate bonds throughout our sample period.
• Each CCBF never holds more than 10 per cent of the fund’s portfolio in equity securities throughout our sample period.

We apply these criteria to all Canadian-domiciled investment funds using holdings data from Morningstar between January 2002 and December 2016. We also exclude a small number of index funds. At the end of 2016, our sample consists of 111 funds.1

Table 1 shows that the number and size of CCBFs have more than doubled since 2007. This growth reflects higher supply and demand for corporate bonds, largely due to low interest rates in that period. These holdings are concentrated. CCBFs account for 5 per cent of Canadian mutual funds and 19 per cent of funds with a fixed-income mandate. At the end of 2016, CCBFs manage 8 per cent of all Canadian corporate bonds outstanding, up from 3 per cent in 2007, and 35 per cent of Canadian corporate bonds held by Canadian mutual funds, up from 18 per cent. Most other Canadian mutual funds have small holdings of corporate bonds relative to the size of their portfolio.

Table 1: CCBFs have grown in number and size

Source: MorningstarLast observation: December 2016

CCBF asset holdings have become riskier

CCBFs have increased holdings of corporate bonds

On average across funds, CCBFs have increased their allocation to corporate bonds over the past 10 years to 46 per cent of their net assets under management, from 37 per cent in 2007 (Chart 1).2 This share has declined since 2012 but remains elevated.

Chart 1: CCBF investment allocation has moved toward corporate bonds

Moreover, the number of funds that hold at least 50 per cent of their portfolio in Canadian corporate bonds has more than tripled since 2007, from 8 to 26 (Chart 2). During that period, funds have reduced their allocation to government and quasi-government securities. Overall, CCBF bond holdings have become riskier and less liquid.

Chart 2: The number of CCBFs holding a large proportion of Canadian corporate debt has increased since 2007

CCBF asset holdings are increasingly exposed to credit risk

On average, CCBFs now hold more government and corporate bonds with lower credit ratings (Chart 3). The allocation to AAA-rated bonds has decreased to 23 per cent, from 30 per cent in 2005, while the allocation to AA and BBB-rated bonds has increased to 42 per cent and 16 per cent, respectively.

CCBFs’ increased allocation to bonds with lower credit ratings could result in higher losses in a downturn. The higher allocation to bonds with lower credit rating reflects both demand and supply factors. Low interest rates have boosted demand for riskier corporate bonds with higher yields. At the same time, low interest rates increased the issuance of corporate bonds by firms taking advantage of lower financing costs. Consequently, BBB-rated bonds account for 10 per cent of the Bank of America Merrill Lynch Canada Broad Market Index (a proxy for the Canadian investment-grade bond market) in 2016, up from 5 per cent in 2005 (Chart 4).

Chart 3: CCBFs bear more credit risk since 2005

Chart 4: The issuance of bonds with more credit risk has also increased since 2005

CCBFs have increased their market exposure to interest rate changes

CCBFs also bear more interest rate risk. Chart 5 shows that, on average, CCBFs have lengthened the duration of their fixed-income portfolio, from 5.5 years at the end of 2009 to 6.7 years in 2016.3

Overall, CCBFs’ allocation to bonds with longer duration implies larger losses following a rise in interest rates. The longer portfolio duration reflects demand and supply changes, similar to the case of higher credit risk. Low interest rates have boosted demand for bonds with longer duration and higher yields. At the same time, firms and governments increased their issuance of bonds with longer maturity, taking advantage of lower financing costs. For example, the average duration of investment-grade debt has increased by around 2 years in advanced economies and by around 1.5 years in Canada since 2009 (Chart 5).

Chart 5: CCBF sensitivity to interest rate changes has increased slightly

CCBF liquidity mismatch risk has also increased

Riskier CCBF holdings found so far suggest that the likelihood of large investor redemptions could increase. Riskier holdings mean that fund returns are more variable and increase the likelihood of negative performance. The evidence in Arora (forthcoming) suggests that negative performance in corporate bond funds is typically followed by larger redemptions.

The potential impact on the bond markets could also increase because CCBFs now hold more corporate bonds. Fund managers could choose to sell assets at discounted prices to meet large redemptions.

This relationship between return, redemptions and asset sales creates a first-mover advantage, since portfolio losses are borne by investors who remain with the funds. Anticipation of redemptions and portfolio losses may become self-fulfilling and mutual funds may become vulnerable to “bank runs” (Chen, Goldstein and Jiang 2010). If bond markets are volatile, large sales would amplify declines in corporate bond market liquidity.

The strength of the first-mover advantage and the impact of large redemptions depend on the funds’ holdings of liquid assets. Chart 6 shows that the portfolio share of cash and equivalents as a percentage of total net assets (liquidity ratio) has declined from 9.3 per cent in 2007 to 5.5 per cent in 2016, on average, the lowest level in 10 years.4 Coupled with the increased holdings of corporate bonds, this result suggests a larger mismatch between the liquidity of CCBFs’ assets and liabilities and a strengthening of the first-mover advantage.

Chart 6: The average liquidity ratio of CCBFs has reached its lowest level since 2007

Are cash holdings enough to cover larger redemptions?

The liquidity mismatch reflects a trade-off. Fund managers have an incentive to reduce holdings of cash and equivalents, because of their drag on portfolio returns. But fund managers also have incentives to hold enough liquid assets to meet redemptions by investors and avoid the costly sales of less-liquid assets.

We assess whether CCBFs hold enough liquidity to meet large redemption requests. Chart 6 compares the liquidity ratio with monthly redemptions observed since 2007. The current share of cash and equivalents would be enough to cover the worst redemptions observed since 2007. Ramirez, Sierra Jimenez and Witmer (2015) also argue that CCBFs and other Canadian bond funds hold enough cash to meet redemption requests under most circumstances. However, investor redemptions greater than those observed historically could exhaust CCBFs' liquid assets.

Conclusion

In this note, we show that CCBFs have more than doubled in number and size since 2007. We also find that CCBFs have increased their exposure to interest rate risk, credit risk and liquidity risk. These results suggest an increase in the likelihood of large investor redemptions with higher potential impact on Canadian fixed-income markets.

At the same time, CCBFs still hold, on average, enough cash and liquid assets to meet redemption requests equivalent to the worst outflows observed since 2007. Overall, we assess that the vulnerability of CCBFs for the Canadian financial system appears to be rising—which warrants close monitoring—but remains low.

Arora (forthcoming) analyzes how Canadian mutual fund performance influences redemptions by investors, while Arora and Ouellet Leblanc (forthcoming) document how CCBFs meet redemption requests. Together, these papers lay the foundation to build stress tests quantifying the likelihood and potential impact of CCBFs’ asset sales on the financial system.

Endnotes

References

1. Arora, R. Forthcoming. “Redemption Run Risk in Canadian Bond Mutual Funds.” Bank of Canada Staff Analytical Note.
2. Arora, R. and G. Ouellet Leblanc. Forthcoming. “How Do Canadian Corporate Bond Funds Meet Investor Redemptions?” Bank of Canada Staff Analytical Note.
3. Bank of England (BoE). 2016. Financial Stability Report (November).
4. Chen, Q., I. Goldstein and W. Jiang. 2010. “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows.” Journal of Financial Economics 97: 239–262.
5. European Central Bank (ECB). 2017. Financial Stability Review (May).
6. Financial Stability Board (FSB). 2017. Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities.
7. Goldstein, I., H. Jiang and D.T. Ng. 2017. “Investor Flows and Fragility in Corporate Bond Funds.” Journal of Financial Economics 126: 592–613.
8. International Monetary Fund (IMF). 2015. Global Financial Stability Report (April).
9. Office of Financial Research (OFR). 2016. Financial Stability Report (December).
10. Ramirez, S., J. Sierra Jimenez and J. Witmer. 2015. “Canadian Open-End Mutual Funds: An Assessment of Potential Vulnerabilities.” Bank of Canada Financial System Review (June): 47–54.
11. Young Chang, B., M. Januska, G. Kumar and A. Usche. 2016. “Monitoring Shadow Banking in Canada: A Hybrid Approach.” Bank of Canada Financial System Review (December): 23–37.

Acknowledgements

We thank Amy Li for research assistance. We are also thankful to Guillaume Bédard-Pagé, Ian Christensen, Jean-Sébastien Fontaine, Maren Hansen and Jonathan Witmer for helpful comments and suggestions.