Do Multi-Sector Bond Funds Pose Risks to Emerging Markets?

Abstract

Emerging economies in the post-crisis period increasingly saw portfolio debt inflows from a type of large international investment fund: Multi-Sector Bond Funds (MSBFs). These investors have lacked adequate representation in the literature. This paper constructs a new detailed database from micro-level MSBF emerging market (EM) holdings from 2009:Q4–2018:Q2. Exploiting this data, the paper assesses the risks they pose to the financial stability of specific emerging bond markets. The data shows that MSBFs are highly concentrated–both in their positions and their decision-making. The empirical results further suggest that MSBFs exhibit opportunistic behavior (and more so than other investment funds). In periods of high risk aversion, large MSBF portfolio reallocations out of EMs can be associated with underperformance of the same markets, signaling the importance of monitoring their footprint and better understanding their asset allocation decisions.

Investment Funds and Financial Stability: Policy Considerations

“…In periods of high-risk aversion, large and concentrated MSBF portfolio reallocations out of EMs can be associated with underperformance of the same markets. This association is particularly strong in local currency bond markets where MSBFs typically have their largest exposures (Cortes and Sanfilippo 2020), which are countries where returns are potentially higher but also riskier. During the COVID-19 outbreak, outflows from MSBFs were responsible for an estimated pullback of $23 billion, almost entirely out of local currency bond exposures.…”

“…Unlike dedicated bond funds, where the decision to invest in EMs rests with the end-investor, MSBF portfolio managers are responsible for asset allocation decisions across fixed income sectors and geographies subject to their own particular investment mandates. As a result, MSBF portfolios typically deviate significantly from benchmarks (Cortes and Sanfilippo 2020). MSBFs are found to have a median active share that has exceeded 70 percent.…”

Risks and Vulnerabilities in the U.S. Bond Mutual Fund Industry

“…The sample is subdivided into nine categories reflecting the type of instruments mutual funds invest in. As shown in Table 3, the categories are IG and HY corporates, loan funds (exposed to leveraged loans), global bond funds, EM funds, government bond funds, municipal bond funds, mixed funds (investing in equities and bonds) and multi-sector funds (which invest in different countries and across fixed income categories, see also Cortes and Sanfilippo;.…”

“…For some of those funds, the high cash buffers can be explained by the use of derivatives such as interest rate swaps and CDSs, as funds keep cash to be able to meet variation margins on their derivatives' positions. Based on sample of funds with assets close to USD 1trillion, Cortes and Sanfilippo (2020) document that such funds are more likely to engage in leveraged derivatives trades.…”