The Bank of England will conduct further assessment of the asset management industry in relation to the corporate bond market, following a paper outlining liquidity concerns in the event of a 'severe' market shock.
In its report, Simulating stress across the financial system: the resilience of corporate bond markets and the role of investment funds, the BoE found that a large round of redemptions from funds investing in corporate bonds could ultimately hurt financial stability.
In particular, it is concerned about about fire sales in one part of the system spreading to other areas, which would make the entire system risky.
The report said: "Under a severe but plausible set of assumptions regarding market participant behaviours, investor redemptions can result in material increases in spreads in the corporate bond market and, in the extreme, in corporate bond market dislocation, threatening the stability of financial markets and institutions.
"While such market dislocation is a tail risk, the probability of it crystallising could increase, especially if the potential demand for liquidity, including that arising from the investment fund sector, continues to grow relative to the supply of liquidity by dealers and other investors."
The bank's analysis found the most severe level of redemptions from all investment grade corporate bond funds was seen in October 2008, when monthly outflows reached 4.2% of assets under management.
It als found that redemptions worth 1% of the total net asset value of bond funds could result in European investment grade corporate bond spreads increasing by around 40bps, while a sell-off of 1.3% of assets could lead to a 70bps widening.
The BoE also pointed to the measures UK open-ended property funds were forced to take in the summer 2016 as an example of potential risks associated with funds' liquidity mismatch.
Alex Brazier, executive director and member of the BoE's Financial Policy Committee, said the research was attempting to answer three key questions:
- What would happen if asset managers find themselves forced to sell bonds into falling markets?
- What if investment banks and insurers had to stop buying?
- What happens in the bond market if there are lots of sellers and not many buyers, and how could that affect the wider economy?
The BoE said that the findings were not only relevant for the assessment of systemic risk, but also "help identify areas and vulnerabilities that warrant monitoring going forward."
It added that its simulation of large scale redemptions illustrated "how the combination of constraints and incentives facing the different parts of the system could, in principle, add up to be an amplifier, even when each individual part of the system may be safe".
"It is another example of how the system may not be the sum of its parts," it said.
In response to the findings, Brazier said further assessment was required in order to meet the bank's goal of building a workable framework for stress testing the stability of the entire market.
"Overall, this work contributes to our ambition of a financial system in which not just the component parts are individually safe but, at the same time, the system as a whole is stable too," he said.
"The economy deserves a financial system that serves it well in both good times and bad; a system that absorbs problems and does not amplify them.
"There is much further to go, so feedback on these steps is welcome from those inside and outside the financial system."
One area for further work, according to the paper, is the use of liquidity management tools, such as suspending redemptions, which was not included in its simulations.
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