Financial Fragility in the COVID-19 Crisis: The Case of Investment Funds in Corporate Bond Markets
In the decade following the financial crisis of 2008, investment funds in corporate bond markets became prominent market players and generated concerns of financial fragility. The COVID-19 crisis provides an opportunity to inspect their resilience in a major stress event. Using daily microdata, we document major outflows in these funds during this period, far greater than anything they experienced in past events. Large outflows were sustained over several weeks and were widespread across funds. Inspecting the role of sources of fragility, we show that both the illiquidity of fund assets and the vulnerability to fire sales were important factors in explaining outflows. The exposure to sectors most hurt by the COVID-19 crisis was also important. By providing a liquidity backstop for their bond holdings, the Federal Reserve bond purchase program helped to reverse outflows especially for the most fragile funds. The impact materialized quickly after announcement and was large over the post-crisis period among funds that held bonds eligible for purchase. In turn, the Fed bond purchase program had spillover effects, stimulating primary market bond issuance by firms whose outstanding bonds were held by the impacted funds and stabilizing peer funds whose bond holdings overlapped with those of the impacted funds. The evidence points to a new "bond fund fragility channel" of the Federal Reserve liquidity backstop whereby the Fed bond purchases transmit to the real economy via bond funds.
Views expressed are those of the authors and do not necessarily represent the views of the Board, its staff, or the National Bureau of Economic Research. We thank Valentin Haddad, Yi Li, Nellie Liang, Yiming Ma, Jeremy Stein, Annette Vissing-Jorgensen, Yao Zeng, and participants at the Brookings Webinar on "COVID-19 and the Financial System - How and Why Were Financial Markets Disrupted?", the Princeton-Stanford Conference on "Corporate Finance and the Macroeconomy under COVID-19", and the Atlanta Fed Conference on "Financial Stability and the Coronavirus Pandemic" for helpful comments and discussions. Jacob Faber provided excellent research assistance. All remaining errors are ours.
Itay Goldstein has been retained by a law firm as an expert on a case involving a liquidity crisis and government intervention in a European bank. This case has not influenced the research in this paper, and the research in this paper has not influenced the case.