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Fed Economist, ICI Debate High-Yield Spillover Effects

A new post from economists at the New York Fed seeks to identify funds vulnerable to runs and to assess the potential spillover effects to other funds if a run occurred. The authors identified the most at-risk funds within the high- yield, corporate bond, and multisector fund categories (representing $280 billion in net assets), ranking funds based on portfolios liquidity, cumulative absolute returns and net flows measured over a six month period. To assess the spillover effects, the authors used a scenario in which 50 percent of investors in the most at-risk fund redeem, causing the fund to liquidate 50 percent of assets, and continuing the shock to each subsequent fund, ranked by risk.

The authors found that a 50 percent shock to each of the at-risk funds would amount to aggregate spillover losses of nearly $9 billion to all open-end funds. The post noted that “no particular fund seems capable—by virtue of its size or asset holdings—to impose significant large fire-sale spillovers on its own.” The authors found that the spillover losses most affect high-yield bond funds with a mean spillover loss of $13 million per fund (excluding losses from the initial shock to the fund), compared to $2.5 million per fund for non-high-yield bond funds and $500,000 per fund for equity funds. According to the authors, these results are not unexpected because the assets of high-yield funds “overlap more with those of the high-yield funds that are fire-selling.” In terms of dollars, the aggregate spillover loss is greatest in the non-high-yield bond fund category at $4 billion, whereas equity funds would suffer more than $1.5 billion in spillover losses and high-yield bond funds would lose around $2.5 billion. The authors concede that “[t]hese numbers seem relatively small and nonsystemic, although they reflect the specific set of assumptions illustrated above.”

The ICI responded to the post, noting that the outflows assumed by the Fed economists are “many times larger than ever seen in history, even during periods of very significant market stress, such as the recent Great Recession.” According to the ICI, the assumption that 50 percent of high-yield bond fund shareholders would redeem at once is an “extremely extreme” assumption and that even in December 2015, the median high-yield bond fund saw median outflows of 2.4 percent. However, even assuming the “massive” outflows, the ICI noted that “the spillover effects are minimal, costing investors at most 23 basis points (0.23 percent) of fund assets.” The ICI describes the $9 billion dollar loss as “nothing to sneeze at,” but an amount that “would be almost lost in the noise of daily market activity” and highlighted that the 23 basis points “is less than the swing in Treasury bond returns on a typical trading day.”