PrefBlog

The Bank of Canada has published a useful analytical note by Rohan Arora, Nadeem Merali, Guillaume Ouellet Leblanc titled Did Canadian Corporate Bond Funds Increase their Exposures to Risks?:

Canadian fixed-income mutual funds have grown rapidly over the past 10 years—15 per cent annually compared with 2.6 per cent for equity funds. These investment vehicles direct a growing share of funds from savers to borrowers and now are a large component of the Canadian shadow banking sector (Young Chang et al. 2016). This note focuses on open-ended mutual funds with large holdings of Canadian corporate bonds, a subset of Canadian fixed-income mutual funds.

Canadian corporate bond mutual funds (CCBFs) are more vulnerable than other funds because of the liquidity mismatch between their assets and liabilities: the funds offer daily redemption to investors yet they invest in relatively less-liquid assets (corporate bonds). This mismatch raises concerns that CCBFs may face large redemption requests during periods of stress (Goldstein, Jiang and Ng 2017). Indeed, in 2017, the Financial Stability Board issued policy recommendations to reduce this vulnerability (FSB 2017).
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In this note, we show that CCBFs have more than doubled in number and size since 2007. We also find that CCBFs have increased their exposure to interest rate risk, credit risk and liquidity risk. These results suggest an increase in the likelihood of large investor redemptions with higher potential impact on Canadian fixed-income markets.

At the same time, CCBFs still hold, on average, enough cash and liquid assets to meet redemption requests equivalent to the worst outflows observed since 2007. Overall, we assess that the vulnerability of CCBFs for the Canadian financial system appears to be rising—which warrants close monitoring—but remains low.

Arora (forthcoming) analyzes how Canadian mutual fund performance influences redemptions by investors, while Arora and Ouellet Leblanc (forthcoming) document how CCBFs meet redemption requests. Together, these papers lay the foundation to build stress tests quantifying the likelihood and potential impact of CCBFs’ asset sales on the financial system.

PerpetualDiscounts now yield 5.46%, equivalent to 7.10% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little over 3.85%, so the pre-tax interest-equivalent spread is now about 325bp, a slight (and perhaps spurious) widening from the 320bp reported March 21.

This entry was posted on Wednesday, March 28th, 2018 at 10:18 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.