Burned by leverage? Flows and fragility in bond mutual funds

Luis Molestina Vivar, Michael Wedow and Christian Weistroffer of ECB in this WP:

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.

Applies to the crisis in India’s bond MFs as well.

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