Market turmoil caused by the coronavirus served as a real-life test for bond funds and their liquidity, according to a new paper from the Bank of Canada.

The amount of corporate bonds held by open-ended fixed-income mutual funds is growing, sitting at around 23 per cent of the total market of corporate Canadian-dollar denominated bonds, up from just 12 per cent in 2007, the central bank noted.

This reality poses a potential liquidity issue, since these bond funds offer daily redemptions while holding assets that can be difficult to sell on short notice, the paper said. As a result, if many investors were to rush to redeem, these funds might be forced to sell corporate bonds, decreasing bond market liquidity.

“Concerns about the economic impact of the pandemic created a shock wave in financial markets in March 2020,” the paper said. “Spreads of Canadian corporate bonds widened significantly, causing the value of bond fund assets to fall. A large share of investors reacted by exiting these funds to raise cash. Net redemptions reached $14 billion in March, amounting to around 4.5 percent of assets under management.”

While these redemptions were significant, they didn’t reach levels predicted by a model simulation based on March credit spreads. This is likely due, at least in part, to the BoC’s liquidity and asset purchase facilities, which helped calm markets, limiting the number of redemptions, the paper said. “Fund managers also played a role in preventing large redemptions by intensifying their relationship efforts with investors (i.e., they had regular conversations about investment decisions). Some fund managers also charged higher fees to investors who exited the fund. The higher fees were deemed necessary because the cost of providing liquidity in this market rose significantly in March.”

As well, it would appear many fund managers were able to meet redemption demands by using cash and other liquid assets, the paper said. Additional flexibility came from securities regulators by allowing fund managers to borrow to manage redemption demand. “Available data indicate that, on average, cash holdings of bond funds declined from 4.2 to three percent of assets under management in the quarter ending in March.”

If these factors hadn’t fallen into place, the paper added, the adverse conditions of the market’s liquidity would have risen. Looking ahead, fund managers have now already used many of the tools at their disposal to mitigate the situation and may be in a weaker position in the event of future market turmoil, especially where the diminishment of their cash reserves is concerned. “By rapidly rebuilding those buffers, bond funds can help avoid future forced sales of assets that are less liquid. The Bank will continue to monitor these funds and how they can affect fixed-income market liquidity.”