Multi-Sector Bond Funds in Emerging Markets—Easy Come, Easy Go

Fabio Cortes; Luca Sanfilippo

doi:10.5089/9781616357689.065.A001

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Multi-Sector Bond Funds in Emerging Markets—Easy Come, Easy Go

Author:

Fabio Cortes

0000000404811396

https://isni.org/isni/0000000404811396 International Monetary Fund

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and

Luca Sanfilippo

0000000404811396

https://isni.org/isni/0000000404811396 International Monetary Fund

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Publication Date:: 16 Dec 2021

eISBN:: 9781616357733

ISBN:: 9781616357733

Language:: English

Keywords:: fixed income holding; MSBF portfolio holding; fixed income market; aggregate emerging market investment; emerging market market portfolio

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Unconstrained multi-sector bond funds (MSBFs) can be a source of spillovers to emerging markets and potentially exert a sizable impact on cross-border flows. MSBFs have grown their investment in emerging markets in recent years and are highly concentrated—both in their positions and their decision-making. They typically also exhibit opportunistic behavior much more so than other investment funds. Theoretically, their size, multisector mandate, and unconstrained nature allows MSBFs to be a source of financial stability in periods of wide-spread market turmoil while others sell at fire-sale prices. However, this note, building on the analysis of Cortes and Sanfilippo (2020) and incorporating data around the COVID-19 crisis, finds that MSBFs could have contributed to increase market stress in selected emerging markets. When faced with large investor redemptions during the crisis, our sample of MSBFs chose to rebalance their portfolios in a concentrated manner, raising a large proportion of cash in a few specific local currency bond markets. This may have contributed to exacerbating the relative underperformance of these local currency bond markets to broader emerging market indices.

Abstract

Portfolio Dynamics—Size and Concentration ¹

Prior to the COVID-19 pandemic, emerging economies increasingly saw portfolio debt inflows from a type of large international investment fund: multi-sector bond funds (MSBFs). The assets of the funds in a sample of 40 large MSBFs have more than doubled since the global financial crisis to about $1 trillion (nearly 10 percent of the entire bond investment fund sector globally). Their aggregate emerging market investment has ranged between $100 billion-$160 billion in recent years (peaking at about $160 billion in 2014), with the bulk of their emerging market exposure invested in sovereign bonds and—to a much lesser extent—bonds of state-owned enterprises. Since MSBFs are unconstrained by benchmarks, they are highly concentrated, both in their positions and their decision-making; exhibit a significantly more opportunistic behavior than other investment funds; and actively use derivatives and leverage. More than two-thirds of the investment in emerging markets from the MSBFs sample is managed by funds that have leverage embedded into derivatives positions. While some MSBFs use derivatives for hedging, others can use it to boost returns. Unlike dedicated bond funds, where the decision to invest in emerging markets rests with the end investor, MSBF portfolio managers are responsible for asset allocation decisions across fixed income sectors and geographies subject to their own particular investment mandates.

MSBFs built up large exposures in the sovereign bonds of various key emerging markets but recently shed exposure close to historic lows, which accelerated since the COVID-19 outbreak. Over the past decade, the sample of 40 MSBFs alone have accounted for more than 20 percent of the foreign investor base of sovereign bond markets, such as Hungary, Malaysia, Ukraine, and Uruguay. More recently, they have exceeded 10 percent of the foreign investor base in Brazil, India, and Mexico (see Figure 2).² MSBFs reached historical lows in their investment concentration in many emerging markets following the COVID-19 crisis (as of the second quarter of 2020) as they rebalanced their portfolios into safer assets and sold positions in response to redemptions. Worryingly, a few selected emerging markets—Brazil and India, in particular—suffered the brunt of the portfolio rebalancing, which likely exerted additional price pressure on those markets. Incidentally, their local bond markets and currencies underperformed in broader emerging market indices during this period.

Benchmark Diversion and Risks

MSBF portfolios not only can move in size, but they typically deviate significantly from benchmarks. The analysis on activism in Cortes and Sanfilippo (2020), which covered the period from the fourth quarter of 2009 to the second quarter of 2018, showed that during “normal” times, MSBFs not only have an absolutely high degree of activism³ (with the median active share exceeding 70 percent,) but compared to benchmark-driven investors (BDIs) and emerging market economy funds—proxied by Emerging Portfolio Fund Research Inc.’s (EPFR) global bond funds and EPFR-dedicated emerging markets funds that report country allocations, respectively, that have an active share below 20 percent. This implies possibly more opportunistic (and potentially unstable) investments by MSBFs, as they more often rotate in and out of investments.

This update extends the sample period from the second quarter of 2018 to the second quarter of 2020, that is, it includes the COVID-19 shock to verify whether MSBFs during tumultuous market times could actually be a potential source of stability. One reason for a stabilizing role is that unlike benchmarked funds, their unconstrained mandate possibly allows a fund manager to hold onto a position in response to a “volatility shock” in one of the assets, rather than contribute to “fire sales,” thereby mitigating the correlation in emerging market fixed income portfolio flows driven by BDIs. To get a true grasp of the degree of activism, MSBF benchmark diversion is compared to EPFR global bond funds during this period.

Benchmark diversion has fallen during recent market stress, but mostly for hard currency holdings. Figure 3 shows that, overall, MSBF’s active share (weighted by currency exposure) has fallen since 2018 and this drop has accelerated since the COVID-19 shock. However, the drop in the degree of activism has been significantly larger in hard currency when compared to local currency holdings—in active share terms, the hard currency index fell by 3.8 percent versus 1.3 percent for the local currency index in 2020. This differentiation is not without consequences as MSBFs have their largest exposures in local currency (nearly 70 percent of their investment in emerging markets over the past decade). Moreover, during the COVID-19 outbreak MSBFs cut their exposure to emerging markets significantly, especially in local currency bonds. The figure also shows that, on average, MSBFs still have a significantly lower active share than EPFR global funds.

While some portfolio reallocation can be expected, MSBFs do not do this in a proportional manner but focus on the bonds of a few selected emerging market sovereign issuers. Unlike dedicated bond funds, where the decision to invest in emerging markets rests with the end investor, the portfolio managers of MSBFs are responsible for asset allocation decisions across fixed income sectors and geographies subject to their own particular investment mandates. Thus, the asset allocation decisions of a few fund managers could be highly concentrated. The activism analysis suggests this behavior is particularly strong in local currency bond markets where MSBFs typically have their largest exposures. Local-currency bond markets typically have higher potential returns (currency and local rates exposure), but they can be also riskier.

During the COVID-19 outbreak, MSBFs were responsible for an estimated outflow of $23 billion, almost entirely out of local currency bond exposures. This portfolio reallocation was not done in a proportional manner, it was concentrated in the local currency bonds of some of the largest and more liquid emerging market sovereign issuers (Brazil and India specially), while MSBFs kept their most illiquid exposures. Figures 4 and 5 show how for the Latin America and Caribbean region, which suffered the largest outflows, the divestments were concentrated in Brazilian local currency bonds while exposures to hard currency bonds remained largely unchanged. In contrast, exposure of MSBFs to less liquid emerging market economies, such as Argentina, remained unchanged, potentially increasing liquidity mismatches in their emerging market portfolios. During the widespread market stress experienced during the COVID-19 shock, MSBF non-benchmarked and concentrated behavior may have contributed to heighten market pressures in the more developed and liquid emerging market bond markets. However, less liquid (and hard currency) markets experienced less MSBF-enhanced volatility during this period of stress. A word of caution: this is not to say that in normal times their proportionally large positions in these illiquid markets do not call for vigilance, as significant reallocation decisions (in the absence of acute stress or redemptions) can still occur.

Redemption Analysis

COVID-19, a shock like no other. While previous episodes of increased risk aversion in the emerging market space provided a glimpse of financial instability risks MSBFs could imply; so far, these shocks did not coincide with wide-spread MSBFs redemptions—isolated redemptions did occur within funds or clustered within fund families (for example, the fourth quarter of 2021, the third quarter of 2015, and the fourth quarter of 2018). By contrast, MSBFs, as a group, reportedly experienced massive outflows when the COVID-19 shock hit, which means portfolio managers were forced to aggressively liquidate positions to raise cash to pay for redemptions. To validate this hypothesis, the authors of this note performed a redemption analysis. Redemptions are defined as returns adjusted for changes in assets under management (AUM).

Figure 6 shows that MSBFs, as a group, suffered large redemptions during the outbreak of the pandemic in the first quarter of 2020—more so than in any other period (by a stretch). It is important to note that the periods of (isolated, clustered, or system-wide) redemptions from MSBFs (with emerging market exposure) coincided with overall risk aversion, suggesting that MSBFs, on balance, do not seem to be a stabilizing force as their forced liquidations, especially in liquid local currency markets (see previous section), tend to exacerbate cross border flows.

Regression Analysis

Large MSBF portfolio reallocations out of emerging markets can be associated with underperformance in the same markets. The observed MSBF reallocation patterns (concentrated and non-benchmarked) and the potentially destabilizing impact implied by the redemption analysis signals the importance of monitoring their footprint and better understanding their asset allocation decisions. To empirically test the implications of their growing role in emerging market fixed income markets, this note builds on the panel regression analysis first presented in Cortes and Sanfilippo (2020) (henceforth, C&S), which suggested that it matters not just that MSBF are investing in emerging markets but also when they are (re)allocating. In periods of risk aversion MSBF reallocations could be associated with a significant underperformance of selected emerging markets. Yet, the analysis in C&S did not account for the recent stress episode, leaving open the question whether during periods of wide-spread financial turmoil MSBFs could be a stabilizing force. The sample, thus, is extended through the second quarter of 2020, to include the COVID-19 shock and the ensuing overall emerging market flows bust and nascent recovery in hard currency.

The impact of MSBFs’ reallocations is assessed from the perspective of currency, local currency bond, and hard currency bond markets. The results are summarized in three main regressions, where the dependent variable in each regression is defined as a performance spread over the respective emerging market benchmark—see Annex 1 for further detail on the regression analysis and methodology. For currencies, this translates into the performance spread of the local currency over the J.P. Morgan Emerging Market Currency Index. For local currency bonds, it reflects performance relative to the J.P. Morgan GBI Diversified Index, and for hard currency bonds relative to the J.P. Morgan EMBI-Global Diversified Index. The main explanatory variable is flows of MSBFs holdings. Therefore, the regressor is defined as the first difference log of MSBF emerging market fixed income holdings, adjusted for the changes solely due to the changes of portfolio assets’ value. Depending on the dependent variable, the regressor reflects local currency holdings (for currency and local currency bonds) or hard currency holdings (for hard currency bonds). Estimations also include an interaction with a (dummy) variable for risk appetite that takes the value 0 in risk-off periods and 1 in risk-on periods to test the hypothesis that the relationship between changes in MSBF holdings and emerging market currencies/bonds is different in a risk-on environment (overall emerging market inflows) versus a risk-off environment (overall emerging market outflows). These are the key results:

For the emerging market currency and local currency fixed income regressions, estimation results show the expected signs and are (statistically) significant (even more so than in C&S). That is, there is a positive relation between changes in MSBF holdings and (i) currency and (ii) local currency bond performance. Worryingly, this implies that, in a period of overall risk aversion, an increase of MSBF outflows in an emerging country allocation of 1 percent is associated with a deterioration in the performance of the (i) currency and (ii) local currency bonds with underperformance over the emerging market (i) Emerging Markets Currency Index (EMCI), and (ii) GBI benchmark by (i) -1.7 and (ii) -1.9 percent, respectively. In a period of inflows, this impact is moderated to (i) -0.3 and (ii) -0.5 percent.⁴
For the hard currency fixed income regression, coefficients are significant, yet, at face value, the sign on the MSBFs flows appears counterintuitive. That is, there is a negative relation between changes in MSBF holdings and hard currency bond performance. Which suggests that an increase of MSBF outflows in an emerging country allocation of 1 percent is associated with outperformance over the emerging market EMBIG benchmark by +0.8 percent. In a period of inflows, this impact is moderated to +0.1 percent. Within the context of the negative association, the positive sign on the interaction term makes sense. As before, in periods of overall inflows, the impact of MSBFs (in this case negative) is moderated, as their marginal impact would be smaller with many other investment funds moving into the same space.

To explain the counterintuitive sign, it helps to underscore the comparative resilience of MSBF hard currency holdings observed in section 2 during the COVID-19 episode. More specifically, local currency holdings saw large, disproportionate outflows during this period of risk-aversion and overall outflows. However, MSBFs’ hard currency fixed income holdings, although adversely impacted, were more resilient and rapidly recovered even though the overall emerging market fixed income market remained under pressure. Consider, then, the liquidity and size of the overall emerging market hard currency fixed income space, as well as the countries MSBF are positioned in, which complicates parsing out the impact solely due to MSBF flows in the empirical estimation.

Advanced Economy vs. Emerging Market Fixed Income Portfolio Dynamics

The focus so far has been on the emerging market fixed income portfolio, but to fully grasp the disproportionate reallocation patterns (as well as contagion potential) of MSBFs, it serves to compare their behavior in advanced economy markets. As before, the data shows the trends in MSBF holdings adjusted for price effects, where the correction for changes solely due to the changes of portfolio asset values is proxied by the Barclays Global Agg. for advanced economy fixed income, and the JP Morgan EMBG and GBI Diversified for emerging market hard and local currency fixed income, respectively.

While advanced economy exposures are larger overall (see Figure 7), Table 1, which summarizes the quarter-over-quarter percent change, shows that the emerging market portfolio bore the brunt of the pain during stress periods, with significantly larger outflows relative to the advanced economy portfolio in the second half of 2018 and the first quarter of 2020. As discussed in previous sections, this is especially the case for local currency (vs. hard currency). In fact, when the advanced economy market calmed down, MSBFs were still pulling out of emerging market local currency, and already recovered some emerging market hard currency.

In sum, MSBFs can retreat in a disproportionate manner from selected emerging market exposures. As a result, rather than acting as a stabilizing force for emerging markets, their actions achieve the opposite: when facing large redemptions, they pull out the rug underneath their largest emerging market exposures to raise cash. By contrast, they are less prone to raise cash by liquidating their exposures to advanced economy bonds, with their advanced economy portfolio displaying some flight to safety behavior (for example, in the second half of 2018) and rebounding much quicker following drawdowns.

^{Table 1.}

MSBF Portfolio (Price-adjusted) Percent Change

Sources: Bloomberg Finance L.P; and authors’ calculations. Note: MSBF Portfolio holdings are adjusted for the changes solely due to the changes in portfolio asset values, where price effects are proxied by the Barclays Global Agg. for advanced economy fixed income and the J.P. Morgan EMBG and GBI Div. for emerging market hard and local currency, respectively. MSBF = multi-sector bond fund.

^{Table 1.}

MSBF Portfolio (Price-adjusted) Percent Change

	Fixed Income	2017 Q1	2017 Q2	2017 Q3	2017 Q4	2018 Q1	2018 Q2	2018 Q3	2018 Q4	2019 Q1	2019 Q2	2019 Q3	2019 Q4	2020 Q1	2020 Q2
Advanced Economy	Total	16.8	0.9	-6.8	6.5	2.6	1.2	2.4	4.5	-8.2	-3.0	27.4	-0.2	-7.9	1.8
Emerging Markets	Total	3.1	2.7	2.1	0.3	4.5	-14.2	-7.5	-1.3	-3.6	7.5	0.5	-3.8	-20.5	6.8
	Local	3.4	2.6	0.2	-3.8	2.5	-20.9	-9.5	-0.4	-8.2	9.6	-10.1	-3.6	-25.1	-6.8
	Hard	2.6	2.9	6.8	9.7	8.5	-1.6	-4.5	-2.5	3.3	4.7	15.1	-4.1	-15.5	19.8

^{Table 1.}

MSBF Portfolio (Price-adjusted) Percent Change

	Fixed Income	2017 Q1	2017 Q2	2017 Q3	2017 Q4	2018 Q1	2018 Q2	2018 Q3	2018 Q4	2019 Q1	2019 Q2	2019 Q3	2019 Q4	2020 Q1	2020 Q2
Advanced Economy	Total	16.8	0.9	-6.8	6.5	2.6	1.2	2.4	4.5	-8.2	-3.0	27.4	-0.2	-7.9	1.8
Emerging Markets	Total	3.1	2.7	2.1	0.3	4.5	-14.2	-7.5	-1.3	-3.6	7.5	0.5	-3.8	-20.5	6.8
	Local	3.4	2.6	0.2	-3.8	2.5	-20.9	-9.5	-0.4	-8.2	9.6	-10.1	-3.6	-25.1	-6.8
	Hard	2.6	2.9	6.8	9.7	8.5	-1.6	-4.5	-2.5	3.3	4.7	15.1	-4.1	-15.5	19.8

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Multi-Sector Bond Funds in Emerging Markets—Easy Come, Easy Go

Author:

Fabio Cortes

and

Luca Sanfilippo

Volume/Issue:: Volume 2021: Issue 005

Publisher:: International Monetary Fund

ISBN:: 9781616357733

Pages:: 12

DOI:: https://doi.org/10.5089/9781616357689.065

Keywords
Portfolio Dynamics—Size and Concentration 1
Benchmark Diversion and Risks
Redemption Analysis
Regression Analysis
Advanced Economy vs. Emerging Market Fixed Income Portfolio Dynamics

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^{Figure 1.}

Multi-Sector Bond Funds: Size and Emerging Market Exposure

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^{Figure 2.}

MSBFs: Concentrated Emerging Market Exposures

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^{Figure 3.}

Multi-Sector Bond Funds Active Shares

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^{Figure 4.}

MSBFs Portfolio Allocation Change

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^{Figure 5.}

MSBFs Portfolio Allocation Change

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^{Figure 6.}

Multi-sector Bond Funds Redemptions

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^{Figure 7.}

Multi-sector Bond Funds Portfolio Fixed Income Holdings

Foresee

^{Table 1.}

MSBF Portfolio (Price-adjusted) Percent Change

	Fixed Income	2017 Q1	2017 Q2	2017 Q3	2017 Q4	2018 Q1	2018 Q2	2018 Q3	2018 Q4	2019 Q1	2019 Q2	2019 Q3	2019 Q4	2020 Q1	2020 Q2
Advanced Economy	Total	16.8	0.9	-6.8	6.5	2.6	1.2	2.4	4.5	-8.2	-3.0	27.4	-0.2	-7.9	1.8
Emerging Markets	Total	3.1	2.7	2.1	0.3	4.5	-14.2	-7.5	-1.3	-3.6	7.5	0.5	-3.8	-20.5	6.8
	Local	3.4	2.6	0.2	-3.8	2.5	-20.9	-9.5	-0.4	-8.2	9.6	-10.1	-3.6	-25.1	-6.8
	Hard	2.6	2.9	6.8	9.7	8.5	-1.6	-4.5	-2.5	3.3	4.7	15.1	-4.1	-15.5	19.8

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Abstract

Portfolio Dynamics—Size and Concentration 1

Benchmark Diversion and Risks

Redemption Analysis

Regression Analysis

Advanced Economy vs. Emerging Market Fixed Income Portfolio Dynamics

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Portfolio Dynamics—Size and Concentration ¹