M-RCBG Associate Working Paper No. 46

Asset Managers and Financial Instability: Evidence of Run Behavior and Run Incentives in Corporate Bond Funds

Jeffrey J. Wang



U.S. financial regulators are currently scrutinizing open-end corporate bond mutual funds due to their immense size, risk-taking behavior, and vulnerability to dramatic outflows. Bond funds may present systemic risk, as investor redemptions trigger asset sales and redemption costs that only impact remaining investors in the fund. Liquidation lag and mark-to-market lag translate these redemption costs into run incentives. This paper first tests for run-like behavior in corporate bond funds and then tests for the underlying run incentive, measured by the NAV impact. I find that illiquid bond funds are significantly more sensitive to past performance than liquid funds and experience up to 43.6% more outflows given a 1% decrease in returns. Furthermore, net flows in bond funds held primarily by institutional investors are less sensitive to performance but more sensitive to illiquidity than flows in funds held by retail investors, suggesting that institutional bond funds may be more vulnerable to runs. Finally, using a novel dataset, I proxy for the illiquidity of a fund’s underlying bonds and quantify the run incentive. Given 10% net outflows, funds that have insufficient cash levels and hold bonds of illiquidity 3-5 deviations from the mean experience a significant decrease in NAV of about 34-49 basis points. This paper contributes to the mutual fund and financial regulation literature by offering new empirical evidence of run behavior and run incentives in corporate bond funds.

Winner of the 2015 John Dunlop Undergraduate Thesis Prize in Business and Government

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