“Intoxicated Investors” Slammed Corporate Bonds

A key culprit behind the precipitous price declines in credit markets during the financial crisis: mutual funds with short investing horizons.

In March 2007, corporate bond spreads over Treasuries were a mere 135 basis points, while spreads on junk bonds stood at 340 basis points. Nine months later, speculative-grade spreads rocketed to the 700-basis-point range and investment-grade bond yields rose to nearly 200 basis points.

What caused corporate bond yields to balloon as the financial crisis deepened in 2007 and 2008? A new working paper from the National Bureau of Economic Research suggests that mounting default rates by issuers were only partly to blame. Just as important, if not more so, was the transmission of contagion from asset-backed-securities markets to corporate debt markets by the actions of institutional investors.

In particular, investors that held both securitized bonds and corporate bonds in their portfolios made sell choices that heavily pressured corporate debt prices. So say professors Alberto Manconi and Massimo Massa of INSEAD and Ayako Yasuda of the University of California, Davis, in their paper, “The Behavior of Intoxicated Investors: The Role of Institutional Investors in Propagating the Crisis of 2007-2008.”

The study found that corporate bonds held by investors that had high exposures to securitized bonds experienced greater price declines in late 2007 and 2008. Why? Securitized bonds (residential and commercial mortgage-backed securities and the like) had become an illiquid asset class, and mutual funds faced the possibility of “massive” redemption requests by individual investors. To meet those requests, the funds — short-horizon funds mostly — had to liquidate assets. Reluctant to offload “toxic” instruments at fire-sale prices, beginning in August 2007 they began selling off their more liquid holdings: corporate bonds.

In the last quarter of 2007, U.S. mutual funds reduced holdings of corporate bonds by $253 billion (-15%) and securitized bonds by $82 billion (-9%), the study found. In contrast, insurance companies increased corporate bond holdings by $60 billion (3%) and securitized bonds by $10 billion (1%). (Insurance companies hold investors to longer lock-up periods and have larger penalties for early withdrawal.) These “portfolio decisions induced a transmission of shocks from the securitization market to the corporate bond market,” the authors write. Sales and yield spreads widened more for corporate bonds held by mutual-fund investors that were heavily exposed to asset-backed securities.

For example, on average, a fund’s increase in holdings of securitized bonds from 0% to 50% translated into a subsequent 70 basis-point rise in the yield spread of corporate bond holdings. In addition, the average investor was more likely to sell its holdings of junk bonds than its investment-grade debt, which contributed to the sharp increase in spreads of lower-rated corporate bonds.

In examining data of quarterly portfolio holdings of institutional investors from the first quarter of 1998 to the first quarter of 2008, the professors found that from 2004 to 2007 mutual funds increased their holdings of securitized bonds threefold. Short-horizon funds (those with high turnover of holdings in a given year, for example) were more heavily weighted to securitized bonds.

Nearly 80% of the securitized bonds held by the sample mutual funds were AAA-rated, while the majority of corporate holdings were investment-grade but lower than AAA-rated. As mutual funds loaded up on securitized bonds, the portion of their portfolios that was AAA-rated rose. “Highly rated securitized bonds were favored by institutional investors, which are constrained to invest mostly in highly rated assets and which wanted to ‘spice up’ their performance for competitive reasons,” the paper says.

According to the authors, the study’s findings have important policy implications. For one, regulations like lock-up clauses that delay panic-induced withdrawals by investors in mutual funds could have prevented the transmission of the crisis. Two, the study suggests that companies that depend on mutual funds as primary bond investors are vulnerable.

The Securities and Exchange Commission introduced new rules this year that bolster the stability of money-market funds, by requiring that a percentage of instruments be held in highly liquid vehicles. So far, however, no rules have been enacted to address the portfolio holdings of mutual funds. The Dodd-Frank bill introduces new oversight of credit-rating agencies, but didn’t specifically address the rating of structured products.

In the meantime, individual investors are pouring capital into bond mutual funds. In the first half of 2010, the net inflow into bonds was $119.7 billion, four-fifths of total net investments, says Strategic Insight. Most of that money went into short- and intermediate-term corporate bond funds.

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