Bond Funds and Fixed-Income Market Liquidity: A Stress-Testing Approach

This report provides a detailed technical description of a stress test model for investment funds called Ceto. The model quantifies how asset sales from investment funds could amplify a sudden decline in asset prices through the liquidity risk premium of the corporate bond market. Ceto is grounded in the literature on agents’ incentives and behaviour: it considers the response of investors to fund performance and the liquidity-management decisions of portfolio managers to meet demands for redemptions. The model also explicitly accounts for the provision of liquidity by broker-dealers and other potential buy-side investors. By accounting for the behaviour of different types of market participants, our approach allows us to account for the rich institutional features of, and heterogeneity within, the Canadian corporate bond market. The model can accommodate a range of different risk scenarios.