A simulation of fixed income liquidity conducted by the bank predicted this level of outflows from open-ended investment grade funds - a third higher than that seen at the nadir of the 2008 crisis - would result in bond dealers and hedge funds being unable to absorb any further sales except at "highly dislocated" prices.
Its historical analysis on how markets react to corporate bond fund redemptions estimated that withdrawals amounting to 1 per cent of sector assets would push spreads some 41 basis points higher.
In October 2008, when outflows reached 4.2 per cent for the month as a whole, the associated impact was a 25 basis point increase in spreads. A repeat of this level of redemptions would have more severe consequences, the study predicted, because of the greater size of the corporate bond fund universe and lower levels of liquidity.
An increase in spreads would perpetuate itself into a “second round” demand for liquidity, the paper added. The increase in corporate spreads would further increase fund redemptions, with a 1 per cent fall in the value of a fund leading to an additional 0.5 percentage point redemption from fixed income funds in general.
In this scenario, the pilot study said bond asset sales “may begin to exceed market intermediaries’ capacity to absorb them". It added: "This we assume to be associated with severe ‘market dislocation’ and prices that are substantially removed from those commensurate with economic fundamentals."
The analysis was based by studying how investors, fund managers and dealers react to normal redemption scenarios in the $6.5trn (£5.1trn) open-ended European corporate bond fund industry. It studied how fund managers met redemptions, and analysed breaking points and spread increases based on behavioural changes.
The paper concluded: “The stress simulation indicates that, under a severe but plausible set of assumptions, investor redemptions can result in material increases in spreads and, in the extreme, in corporate bond market dislocation.
“The probability of [dislocation] crystallising could increase if the potential demand for liquidity arising from the investment fund sector continues to grow relative to the supply of liquidity by dealers and other investors.”
The report authors found that other scenarios would also impact the ‘breaking point’ of the market, as well as the change in corporate bond spreads. If fund managers used cash holdings rather than selling securities, spreads would rise by 27 basis points rather than 40, the paper predicted.
“Some empirical evidence suggests fund managers use cash to meet redemptions. Such behaviour might reduce the impact on market prices…however during stress, could also lead to a ‘first mover advantage’ being perceived by investors. This might — in the longer run — lead to larger redemptions,” it added.
However, the paper acknowledged that its model could not account in full for the increase in spreads seen in 2008. It said this may have been because hedge funds did not provide the presumed levels of liquidity, or because other market participants such as pension funds were also selling bonds.
The BoE said investor redemptions typically forced fund managers to sell bonds either to hedge funds or clearing houses, with the latter normally absorbing anything the former did not buy.
A clearing house's ability to hold bonds has the most impact on corporate bond spreads, according to the report. Moves are based on the quantity of bonds able to be bought, how long the bonds can be held for, and the regulatory cost of doing so.
"Investor redemptions one third higher than those observed during the crisis could be sufficient [to cause market dysfunction] - an unlikely, but not impossible, event," said BoE executive director Alex Brazier.
The BoE described the study as an important first step, but Mr Brazier added: "It is too soon to use simulations like this to draw policy conclusions."
