Burned by Leverage? Flows and Fragility in Bond Mutual Funds

47 Pages Posted: 19 May 2020

See all articles by Luis Molestina Vivar

Luis Molestina Vivar

European Central Bank (ECB); Goethe University Frankfurt

Michael Wedow

European Central Bank (ECB) - Directorate Financial Stability and Supervision

Christian Weistroffer

European Central Bank (ECB)

Date Written: May, 2020

Abstract

Does leverage drive investor flows in bond mutual funds? Leverage can increase fund returns in good times, but it can also magnify investors’ losses and their response to bad performance. We study bond fund flows to provide new evidence for the link between mutual fund leverage and financial fragility. We find that outflows are greater in leveraged funds during stressed periods and after bad performance, compared with unleveraged funds. We provide supporting evidence that leverage exacerbates the negative externality in investors' redemption decisions. In this regard, we find that fund managers in leveraged funds react more procyclically to net outflows compared with fund managers in unleveraged funds. Such procyclical security sales in leveraged funds may increase investors’ first-mover advantages and their response to bad performance. These findings suggest that leverage amplifies fragility in the bond mutual fund sector.

Keywords: bond funds, financial fragility, fund leverage

JEL Classification: G01, G20, G23

Suggested Citation

Molestina Vivar, Luis and Wedow, Michael and Weistroffer, Christian, Burned by Leverage? Flows and Fragility in Bond Mutual Funds (May, 2020). ECB Working Paper No. 20202413, Available at SSRN: https://ssrn.com/abstract=3605159

Luis Molestina Vivar (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Michael Wedow

European Central Bank (ECB) - Directorate Financial Stability and Supervision ( email )

Frankfurt a.M.
Germany

Christian Weistroffer

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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