When bankruptcy looms, market actors scramble for liquidity. Ideally, they will be matched with liquidity providers, such as mutual funds, to replace their illiquid assets with the liquidity provision they desperately need. In fact, the liquidation happens way before any real bankruptcy. When a corporate bond is downgraded from Investment grade to Junk grade, the liquidation is already happening in the corporate bond market. This is a so-called fire-sale and the bonds involved in the fire-sale are called fallen angels.
It seems straightforward: an institution holder is willing to unload the troubled assets at a steep discount, and a liquidity provider like a mutual fund is willing to buy those downgraded assets for the prospect of excess return on the investment, or alpha. The market has brought the interests of supply and demand together. Regulatory changes and capital constraints of the market can, however, stymie these transactions. But despite living in the wake of the Dodd-Frank Act of 2010, the greatest overhaul of the financial regulatory system since the Great Depression, few researchers have empirically explored the roadblocks to liquidity provision in the current market.
The University of Arkansas’s Xinde Zhang and co-authors, Z. Jay Wang (University of Oregon) and Hanjiang Zhang (Washington State University), have illuminated some of the unintended consequences caused by Dodd-Frank. Using data from January 2002 to June 2016, their research focuses on the role of mutual funds as liquidity providers to insurance companies through the purchase of fire-sale bonds. They show that while mutual funds are important providers of liquidity, this activity has been reduced in the regulatory climate of Dodd-Frank. Their research also suggests a way to identify the investment ability of fund managers.
Slow-moving Capital
In “Fire Sales and Impediments to Liquidity Provision in the Corporate Bond Market,” Zhang’s research contributes to the wider conversation around slow-moving capital, whereby various market frictions delay capital’s formation and arrival when liquidity is needed. In other words, slow-moving capital signals market inefficiency.
While the problem of inefficient markets is multifaceted, Zhang and his fellow researchers focus on two causes: increased search costs associated with regulatory change and capital constraints. Specifically, the capital restraints imposed by the Basel 2.5 and Basel III Accords seem to “severely hinder [mutual funds’] ability to mediate the movement of capital to investment opportunities,” such as fire-sale bonds. This hindering is exasperated by Dodd-Frank’s Volcker Rule, which significantly undercuts dealers’ market-making ability, increasing trading costs and search delays.
Indeed, mutual funds, though important liquidity providers for insurance companies during such fire sales, reduced their liquidity provision activity by about 15% in the Dodd-Frank era. And although fewer fire-sale bonds have been on offer from insurance companies since Dodd-Frank, the decline in demand has outstripped the decline in supply of the bonds. Capital just isn’t going where it is needed.
Barriers to Liquidity Provision
During fire sales, Zhang, Zhang, and Wang find that “mutual funds mainly rely on drawing
down liquid assets to finance the purchase of [fire sale bonds]” rather than liquidating
other market positions. They posit this is due to the cost of liquidating those position.
In any case, even though mutual funds are not directly affected by new regulation,
their own need for liquid assets to finance these transactions creates a barrier to
liquidity provision because the Dodd-Frank regulatory environment constrains the capital commitment of other market
dealers, who would normally also help provide liquidity. Furthermore, this regulatory climate
increases the difficulty of mutual funds unwinding these bond positions, making them
less attractive from the get-go.
As Zhang and the other researchers note, earlier research has suggested this scenario of locked up capital “can magnify the negative price impact of liquidity shocks.” Put another way, it slows the market’s ability to recover when corporate bonds are downgraded. Quite simply, mutual fund managers have excess capital they cannot use in this situation since it is risky to liquidate other investment positions. This risk is especially keen because investors “are more sensitive to poor performance when the funds hold illiquid stocks.” Also, fund managers must maintain a buffer in the case of, say, a slew of redemption requests, which makes it harder to balance the fewer liquid assets the fund tends to hold.
Knock-on Effects for the Mutual Fund Investor
Fire sale bonds take about two years to recover after being downgraded. That said, active liquidity providers, according
to the study’s data, also tend to hold onto these fire-sale bonds long enough for
them to recover their fundamental value. This translates to the most active liquidity
providers returning about 16% more on average from their fire-sale bond investments.
Zhang and his researchers found that “there is a strong positive relation between the [total proportion of a fund’s dollars to purchase fire sale bonds] and subsequent fund performance.” That is, mutual funds which provided the most liquidity to the market through fire sale bonds saw an adjusted excess return of around 150 base points per year, outperforming the bottom quintile of liquidity providers by about 60 base points per year. This outperformance occurred even when the researchers controlled for a variety of characteristics between funds.
The researchers specifically observed that the most active liquidity providers achieved this outperformance through superior bond selection skill mainly with their speculative-grade (i.e., BB+ or lower) holdings. The data shows that active liquidity provision correlates with overall investment skill beyond just trading fire-sale bonds. The researchers argue that the data suggests liquidity provision is broadly indicative of fund management skills.
So, while Zhang, Zhang, and Wang found that there is relatively less liquidity provision in the market during the Dodd-Frank era because of new regulatory constraints, the act of liquidity provision is still an important signal for investors as they vet fund managers.
