Prepared by Lennart Dekker, Luis Molestina Vivar, Michael Wedow and Christian Weistroffer
Published as part of the Financial Stability Review, November 2022.
Liquidity mismatch between assets and liabilities continues to be a key vulnerability in open-ended investment funds. A mismatch arises if funds give their investors the option of short-term redemptions, while at the same time investing in assets that cannot easily be liquidated at short notice. Existing evidence suggests that a larger liquidity mismatch makes it more difficult for funds to meet sudden, large redemption requests from investors, increasing the risk of procyclical asset sales and fund suspensions in response. This can adversely affect other investors and underlying markets.
In 2017 the Financial Stability Board (FSB) responded to the growing size of the investment fund sector and the concern that financial stability risks had increased by publishing policy recommendations to address structural vulnerabilities related to asset management activities. The recommendations aim to reduce liquidity mismatch and enable funds to better deal with liquidity shocks by tying the liquidity of fund assets to the redemption terms offered to fund investors. Specifically, FSB Recommendation 3 encourages authorities to enact requirements or guidance stating that funds’ assets and investment strategies should be consistent with the terms and conditions governing fund unit redemptions, including in periods of stress.
This box assesses the recent development of liquidity mismatch for a broad sample of euro area open-ended bond funds which offer daily redemptions and invest in less liquid assets to varying degrees. In particular, the box aims to shed light on whether liquidity mismatch and associated vulnerabilities have declined since the FSB recommendations were published in 2017, with a particular focus on the coronavirus (COVID-19) crisis.
During the pandemic, many open-ended bond funds, especially those with a relatively large structural liquidity mismatch and higher exposures to credit risk, faced substantial redemption pressures. Chart A (panel a) shows that funds invested in less liquid bonds, such as high-yield or emerging market bonds, faced more severe outflows in March 2020 than sovereign bond funds which are considered more liquid. In response to the market-wide shock, investment funds engaged in procyclical asset sales that in many cases exceeded outflows, thereby contributing to the wider market stress.
Mixed bond funds can also contribute to market-wide stress if they invest in less liquid assets, suggesting it is important to broaden monitoring of liquidity mismatch to a wider set of funds. At the end of 2021, the euro area bond mutual fund sector comprised €2.3 trillion in total net assets, of which around €170 billion was held by sovereign funds, €330 billion by investment-grade corporate funds, €240 billion by high-yield funds and €220 billion by emerging market bond funds. Mixed bond funds accounted for approximately €1.3 trillion in total net assets – more than half the assets managed by all euro area open-ended bond funds. At first sight, mixed bond funds faced somewhat milder outflows at the onset of the pandemic than other (non-sovereign) bond funds (Chart A, panel a). However, mixed bond funds with bigger corporate bond weights experienced large redemption pressures as well (Chart A, panel b). In addition, a large share of mixed bond funds’ assets is held by funds investing predominantly in corporate bonds (Chart B, panel a, green bars). This suggests that mixed bond funds can also be exposed to significant liquidity and credit risk despite their potential broader diversification across asset classes.
The onset of the pandemic led to major outflows from bond funds during March 2020, with funds invested in less liquid bonds facing larger outflows
The total assets of funds that mainly invest in less liquid assets increased from 2015 to 2021 while their cash holdings decreased until 2018, contributing to increased liquidity mismatch during this period. Total net assets of funds predominantly invested in less liquid assets almost doubled to nearly €1.2 trillion between 2015 and 2021, now accounting for more than half of euro area bond funds’ total net assets (Chart B, panel a). Meanwhile, the share of cash in those funds decreased between 2015 and the end of 2018 (Chart B, panel b). This suggests that their liquidity mismatch increased during this period, given that the majority of funds continue to offer daily redemptions. When comparing cash levels at the end of February 2020 with funds’ outflows in March 2020, roughly half of the funds that predominantly invest in less liquid assets experienced outflows that exceeded the level of their cash holdings. Following the beginning of the pandemic, funds that were primarily exposed to less liquid assets materially increased their cash holdings in 2020 and 2021, suggesting procyclical behaviour in liquidity management among fund managers.
Total assets of funds that are mainly exposed to less liquid assets have increased, while their cash holdings decreased up to the end of 2018 and increased materially after the pandemic started
Liquidity mismatch is prevalent in euro area open-ended bond funds and has not declined since the FSB recommendations were published in 2017. The findings in this box illustrate that the asset composition of euro area bond funds is a key factor influencing the level of redemptions during periods of market stress. Asset composition is also an important factor in determining a fund’s ability to meet large redemptions under stressed market conditions. Although most funds that mainly invest in less liquid assets did not have sufficient cash to meet their March 2020 outflows with cash, funds with lower asset liquidity generally tend to hold higher levels of cash than funds investing in more liquid assets. But asset managers do not necessarily have incentives to maintain sufficient levels of liquid assets, as suggested by the procyclical response to the pandemic shock. Policies that aim to better align redemption terms with asset liquidity and investment strategy would thus help to enhance the resilience of open-ended funds, especially in stressed market conditions. Such measures could include notification periods or lower redemption frequencies on the liabilities side and larger liquidity buffers on the assets side, which could be complemented by anti-dilution tools like swing pricing.
I'm an expert in financial stability and investment fund dynamics, with a deep understanding of the challenges posed by liquidity mismatches between assets and liabilities. My expertise is demonstrated through a thorough analysis of the concepts discussed in the provided article.
The article, authored by Lennart Dekker, Luis Molestina Vivar, Michael Wedow, and Christian Weistroffer, is part of the Financial Stability Review from November 2022. It addresses the persistent issue of liquidity mismatch in open-ended investment funds and its implications for financial stability.
The key concepts covered in the article include:
Liquidity Mismatch: The central concern highlighted is the liquidity mismatch between assets and liabilities in open-ended investment funds. This occurs when funds offer short-term redemptions to investors while investing in less liquid assets that cannot be easily liquidated on short notice.
Financial Stability Board (FSB) Recommendations: In response to the growing size of the investment fund sector, the FSB published policy recommendations in 2017. These recommendations aim to address structural vulnerabilities related to asset management activities, specifically targeting the reduction of liquidity mismatch.
Impact of Liquidity Mismatch During the COVID-19 Pandemic: The article examines the developments during the COVID-19 pandemic, revealing that open-ended bond funds, especially those with larger structural liquidity mismatches and higher exposures to credit risk, faced significant redemption pressures. Procyclical asset sales contributed to wider market stress.
Asset Composition and Fund Outflows: The composition of assets in euro area bond funds is identified as a crucial factor influencing the level of redemptions during market stress. Funds predominantly invested in less liquid assets experienced larger outflows during the onset of the pandemic.
Increase in Total Assets and Cash Holdings: The analysis shows that the total net assets of funds predominantly invested in less liquid assets nearly doubled between 2015 and 2021, comprising more than half of euro area bond funds' total net assets. However, their cash holdings decreased until the end of 2018, contributing to increased liquidity mismatch. After the pandemic started, funds increased their cash holdings, indicating procyclical behavior in liquidity management.
Need for Policy Measures: The article suggests policy measures to align redemption terms with asset liquidity and investment strategy, enhancing the resilience of open-ended funds, especially in stressed market conditions. Proposed measures include notification periods, lower redemption frequencies, larger liquidity buffers, and anti-dilution tools like swing pricing.
In conclusion, the evidence presented in the article underscores the ongoing challenge of liquidity mismatch in euro area open-ended bond funds and emphasizes the importance of implementing policy measures to mitigate associated risks and enhance financial stability.