Large scale redemptions from investment funds could spark turbulence in the corporate bond market and threaten the stability of financial markets and institutions, according to a new paper published by the Bank of England.

The paper - which is intended as a first-step in developing a financial system-wide stress simulation framework - looked at how the behaviour of several sectors like investment funds and broker-dealers could “interact to spread and amplify stress” in corporate bond markets.

“Under a severe but plausible set of assumptions regarding market participant behaviours, investor redemptions could result in material increases in spreads in the corporate bond market and, in the extreme, in corporate bond market dislocation, threatening the stability of financial markets and institutions,” the paper said. 

Explaining the rationale behind the paper, Alex Brazier, executive director and member of the Financial Policy Committee, said a key priority for the Bank was to assess how the non-bank part of the financial system, which includes investment funds, pension funds and sovereign wealth funds, responds to economic shocks.

He noted that globally, assets held by non-bank financial intermediaries had increased by more than a third since the financial crisis. And while this growth had been beneficial, Brazier said the new structure of the system had yet to be tested by “severe shocks”.

The Bank’s simulation model found that weekly levels of redemptions from funds equivalent to 1% of their total assets — levels experienced in the financial crisis — could increase corporate bond interest rates for companies with high credit ratings by around 40 basis points.

The model also examined the scale of redemptions that would be needed to overwhelm the capacity of dealers to absorb those sales, resulting in market dysfunction.

“Investor redemptions one third higher than those observed during the crisis could be sufficient for this to happen — an unlikely, but not impossible, event,” Brazier said.

And while such market dislocation was a “tail risk”, the paper said the probability of it crystallising could increase, especially if the potential demand for liquidity, including that arising from the investment fund sector, continued to grow relative to the supply of liquidity by dealers and other investors.

“[This paper] has allowed a scenario to be explored in which large scale redemptions from open-ended investment funds trigger sales by those funds, with resulting spillover effects to dealers and hedge funds,” Brazier said.

The paper noted funds’ liquidity mismatch during the summer of 2016, when following the Brexit vote, a number of UK open-ended property funds experienced significant outflows and had to suspend any further redemptions.

Brazier said that while it was too soon to use these simulations to draw policy conclusions, they could be used to inform macroprudential policies regarding market-based finance activities; the appropriate level of bank resilience and the “precise design of regulations placed on banks and others to ensure that their individual safety is achieved as far as possible in a way that also promotes the stability of market-based finance”.

The paper was written by Yuliya Baranova, Jamie Coen, Pippa Lowe, Joseph Noss and Laura Silvestri.