Institutional funds, which are set up as specialised funds in Germany, manage the assets of a few institutional investors, mostly smaller banks and insurers, but also pension funds, foundations and churches. Unlike retail funds, they are only available to experienced (institutional) investors, often have more flexible investment mandates and prescribe longer redemption notice periods for fund shares. Institutional funds make up the majority of German investment funds and managed three-quarters of the assets under management of all German investment funds at the end of June 2017.
Institutional funds’ reach for yield
In recent years, global interest rates have fallen significantly. Yields on new investments in bonds issued by many governments and enterprises are even negative at present. The literature has shown that falling interest rates lead to an increase in the risk appetite of private investors, but also of banks, insurers and retail funds (e.g. Hanson and Stein 2015, Becker and Ivashina 2015, Choi and Kronlund 2018). In a new study (Barbu et al. 2021), we examine whether this development leads to an increase in the risk appetite of institutional funds. For our analysis, we use the investment fund statistics collected by the Bundesbank, which has recorded the portfolios of all investment funds registered in Germany in detail on a monthly basis since 2009. Our focus is on institutional bond funds and mixed funds that hold euro-denominated bonds. In the period we observed – from November 2009 to June 2017 – the level of risk in the bond portfolios of these funds grew significantly. The average bond credit rating went down by two notches, from AA+ to AA- (S&P scale). At the same time, average duration – a measure of interest rate risk – increased by just under one year. These changes extend far beyond the adjustments that banks, insurers and retail funds made to their bond portfolios, for example, over the same period. As this period was shaped by falling and negative interest rates as well as declining risk premia, it is reasonable to assume that, on average, the increased level of risk in the fund portfolios was driven by reaching for yield in response to falling interest rates.
In order to separate the intentional increase in portfolio risk from pure valuation effects, we measure the reach for yield as the change in the total portfolio yield from one month to the next as a result of transactions. According to this measure, reaching for yield was especially pronounced in the period from 2012 to 2015, during which the majority of funds increased the level of risk in their portfolios (see Figure 1).
Figure 1 Reach for yield over time (basis points)
Source: Deutsche Bundesbank
In various regression analyses, we are able to provide evidence that the reach for yield increases when there is a reduction in the interest rate on the funds’ bond portfolios. To this end, we decompose the interest rate into two components that proxy for credit and interest rate risk:
- The credit risk component of a bond is calculated as the interest rate spread vis-à-vis the German zero-coupon Bund rate with an equivalent maturity.
- The interest rate risk component is computed as the difference between the rate on the above-mentioned zero-coupon Bund of equivalent maturity and the short-term Bund rate.
We find that for a one percentage point compression of the interest rate risk component for their existing bond portfolio, institutional funds purchase bonds in the following month with yields that are, on average, 42 basis points higher. Following an equivalent change in credit risk, funds invest in bonds with yields that are 16 basis points higher. Their investment behaviour is therefore procyclical – funds increase their share of riskier bonds when their prices rise and reduce their share of riskier bonds when their prices fall.
Investment behaviour still procyclical during coronavirus crisis
We also observed institutional funds engaging in such procyclical investment behaviour at the beginning of the coronavirus pandemic in February and March 2020. The prices of government bonds issued by the countries initially hit hardest by the pandemic in the euro area (Italy, Spain and France) fell rapidly. At the same time, the prices of bonds issued by countries that were affected to a lesser degree, such as Germany, remained relatively unchanged. Figure 2 shows that German institutional funds sold a total volume of around €1 billion worth of the crisis countries’ bonds within a short period of time, despite bond prices declining sharply in these countries. At the same time, they bought around €300 million worth of sovereign bonds from other euro area countries – primarily bonds with short maturities. This indicates a reduction in risk during times of acute financial market stress, which is usually consistent with an increase in investors’ risk aversion as well as rising risk premiums, and thus confirms the marked procyclical behaviour of German institutional funds, even during the coronavirus crisis.
Figure 2 Institutional funds’ net transaction volume during the Covid crisis (€ billion)
Source: Deutsche Bundesbank
Interest rate volatility attributable to reach for yield
Using individual securities holdings data, we examine whether this procyclical investment behaviour increases asset price volatility. To this end, for the period from 2009, we compare the monthly yields of all European corporate and government bonds held by German institutional funds to the total net purchases of these bonds by German institutional funds in the previous month. This involves controlling for the corresponding net purchases by other sectors, such as banks, credit institutions, insurers and pension funds. Our regression analysis shows that institutional funds have a significant and lasting impact on bond excess returns. This applies especially to funds which are particularly inclined to reach for yield and to bonds with lower ratings or longer maturities. In Figure 3, the left panel shows that net purchases by funds which are in the top 20% of all funds in terms of reaching for yield lead to significant excess returns in the following 12 months. The right panel shows that funds in the bottom 20% have an effect on excess returns that lasts for a shorter period of time only.
Figure 3 Demand on excess returns depending on the intensity of the reach for yield (RFY) (percentage points)
Source: Deutsche Bundesbank
Incentives in the fund sector promote the reach for yield
Given their stable liabilities compared with retail funds, the procyclical investment behaviour of institutional funds initially seems puzzling. However, we are able to empirically attribute this behaviour to implicit incentives for fund managers and explicit yield targets.
We demonstrate that implicit incentives for a risky investment strategy arise because institutional investors penalise a less risky investment strategy. As investors review their fund holdings on a regular basis, managers time their investment decisions to reach for yield particularly in the months leading to the next review. On average, funds with a comparatively low reach for yield are three times as likely to have their mandate terminated by investors than funds which reach the most aggressively for yield. This effect reverses, however, in times of increased financial market stress and correspondingly higher risk aversion among fund investors, who then increasingly terminate their investment mandates with the funds which were previously operating comparatively aggressively.
Explicit yield targets for fund managers also incentivise the reach for yield, particularly in a negative interest rate environment. Such targets are set, inter alia, by funds which offer a guaranteed return on investors’ capital. Correspondingly, the portfolios of guarantee funds are usually less risky compared with the portfolios of other specialised funds, since guarantee funds try to use their investments in comparatively safe bonds to eliminate losses for their investors. However, negative interest rates pose a challenge for guarantee funds in terms of being able to honour their guarantees. In fact, we are able to demonstrate that guarantee funds are more inclined to reach for yield as the share of negative-yield bonds in their portfolios increases.
Institutional funds manage the bulk of investment funds’ assets under management in Germany. Although these funds have a relatively stable investor structure, their behaviour is strongly procyclical – they buy bonds when their prices rise and sell them when prices fall. Central banks and supervisors are well advised to keep a close eye on institutional funds as this behaviour intensifies asset price volatility.
Barbu, A, C Fricke and E Mönch (2021), “Procyclical Asset Management and Bond Risk Premia”, CEPR Discussion Paper 15123.
Becker, B and V Ivashina (2015), “Reaching for Yield in the Bond Market”, The Journal of Finance 70(5): 1863-1901
Choi, J and M Kronlund (2018), “Reaching for Yield in Corporate Bond Mutual Funds”, The Review of Financial Studies 31(5): 1930-1965.
Coval, J and E Stafford (2007), “Asset Fire Sales (and Purchases) in Equity Markets”, Journal of Financial Economics 86: 479-512.
Guerrieri, V and P Kondor (2012), “Fund Managers, Career Concerns, and Asset Price Volatility”, American Economic Review 102(5): 1986-2017.
Hanson, S G and J C Stein (2015), “Monetary Policy and Long-term Real Rates”, Journal of Financial Economics 115(3): 428-448.