Asia-Pacific Journal of Financial Studies(AJFS)

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11 Reaching for Yield or Playing It Safe? Risk Taking by Bond Mutual Funds Jaewon Choi(Univ. of Illinois) Mathias Kronlund(Univ. of Illinois) The sustained run of easy monetary policies implemented by the Federal Reserve following the Great Recession have seen investors flocking to corporate bond mutual funds. Assets under management by corporate bond funds has grown rapidly: Their holdings of corporate bonds more than doubled from 2007 to 2013, totaling over 1.7 trillion dollars at the end of this period. 1 Practitioners nevertheless have suggested out that these corporate bond funds are increasingly buying bonds with higher yields than their benchmarks to make their performance to look better. 2 Despite the increased importance of corporate bond mutual funds, few studies have examined their risktaking behaviors. As Rajan (2005) notes, investors may have a strong preference to look for relatively higher-yield bonds when interest rates are low. Becker and Ivashina (2014) show that insurance companies reach for yield, and that this behavior is particularly strong in the years before the financial crisis. The incentives tha drive may drive mutual funds to reach for yield differ from those that drive insurance companies to do so. Unlike insurance companies, mutual funds are not subject to rating-based regulation or capital requirements. Rather, corporate bond funds are incentivised to attract more flows by showcasing superior returns. 3 If funds can beat benchmarks simply by taking on more risk and if unsophisticated investors do not evaluate performance on a risk-adjusted basis (Sensoy (2009) and Del Guercio and Reuter (2014)), funds have strong incentives to reach for yield. But it is an open empirical question whether funds that reach for yield can outperform their benchmarks and thus attract more flows. In this paper, we examine reaching for yield by U.S. corporate bond mutual funds. We find that corporate bond

12 funds reach for yield by holding comparatively higher-yield non- AAA-rated investment-grade bonds when compared with U.S. corporate bond indices. The magnitude of reaching for yield depends on market conditions, and is stronger when the level and slope of the yield curve are low and the default spread is narrow, and thus when aggregate investment opportunities in high-yielding securities are scarcer. We find that young and small funds with high expense ratios engage in reaching for yield to a greater extent. Our evidence also suggests that funds attract more flows when they reach for yield. Specifically, flows respond positively (negatively) to active portfolio adjustments towards a greater (less) extent of reaching for yield. The higher yield does not, however, come for free: We find that any superior returns realized by funds that reach for yield can be explained by their betas on common risk factors. In other words, funds that reach for yield do not have superior bond picking skill; they merely load on these risk factors, but investors nevertheless direct flows towards these funds. In contrast to the vast body of literature on portfolio choices made by equity mutual funds, few studies have examined the holdings of corporate bond mutual funds. 4 This is undoubtedly because comprehensive data on mutual funds corporate bond holdings and corporate bond pricing are not readily available. We employ unique data on the corporate bond holdings of U.S. openended bond mutual funds from Morningstar and corporate bond pricing data from Reuters (also known as Bridge/EJV database) to conduct a thorough investigation of reaching for yield by corporate bond funds. We make the following contributions to the literature. We document the extent to which U.S. corporate bond mutual funds reach for yield. Among investment-grade bonds, reaching for yield is most pronounced with BBB- and A-rated bonds. Specifically, the bonds in these ratings categories that are held by corporate bond mutual funds on average have higher yields than those in the Barclays Aggregate Corporate Bond Index (the Agg ) by 20~23 basis points annually. In contrast, we find negative reaching for yield among funds AAA bond holdings; this pattern is particularly strong during the 2008 financial crisis and thus consistent with the phenomenon known as flight to quality. Interestingly, we also find negative reaching for yield ( playing it safe ) in high-yield (or junk ) bonds. This evidence shows that corporate bond funds engage in reaching for yield primarily in the non-aaa investment-grade rating classes. Next, we examine which macro-level variables and fund characteristics predict the time-series and crosssectional variation in reaching for yield. In the time series, funds reach for yield to a greater extent when both the level and slope of yield curves are low, consistent with a hypothesis whereby when average premia are low, funds substitute towards relatively higher-yielding bonds. Further, when the default spread is narrow and thus risky bonds are relatively more expensive, funds also reach for yield to a greater extent. Among cross-sectional fund characteristics, we find that young and large funds with high expense ratios display a greater tendency to reach for yield. This evidence suggests that fund-level incentives are related to the funds preferences to hold relatively higher-yielding bonds. Having documented the extent to which corporate bond mutual funds reach for yield, we ask whether this investing behavior results in higher flows from investors. We employ a novel decomposition of changes in reaching for yield into active (caused by changes in holdings) and passive (caused by bond price movements) components. The active component of reaching for yield captures funds marginal choice in portfolio holdings of higher-yield bonds, while the passive component captures mechanical changes in the reaching-for-yield measure driven by bond price changes. We find that future fund flows react positively to an increase in active reaching for yield, whereas they react negatively to passive reaching for yield. These results show that funds have strong incentives

13 to actively change portfolio holdings and chase higher-yielding bonds. Also, the evidence is consistent with anecdotal evidence that many mutual fund investors take into account fund yields (as well as past performance) when they decide on fund investment allocations. Lastly, we examine the performance implications of reaching for yield. 5 In Fama-MacBeth regressions of individual mutual fund performance, we find that funds that reach for yield to a greater extent tend to have higher returns. Similarly, in a portfolio approach, returns on a portfolio of funds in the highest reaching-for-yield tercile are higher than are those on a portfolio of funds in the lowest reaching-for-yield tercile, by 0.18% monthly. However, the superior performance achieved by funds that reach for yield is fully explained by higher risk. When we regress returns on a long-short high-minus-low reaching-for-yield portfolios on the bond-level risk factors of Fama and French (1993), the alphas are all indistinguishable from zero. Moreover, when we evaluate funds performance by considering time-variation in risk-taking driven by reaching for yield, we find evidence indicating that funds that display the highest reaching for yield actually perform worse than funds that reach for yield less. These results show that superior fund returns generated by reaching for yield are due mainly to taking on more risk, rather than a result of the bond-picking skill of these fund managers. Our empirical results show the extent to which U.S. corporate bond funds engage in reaching for yield and its implications for mutual fund investors. The main vehicle for reaching for yield is non-aaa corporate bonds. By contrast, funds play it safe with high-yield bonds and also hold extremely safe AAA bonds, particularly during the 2008 financial crisis. They hunt for higher yields when high-yielding investment opportunities in the fixed income markets are scarcer. Funds that reach for yield display higher returns and attract more flows but, on a risk-adjusted basis, these funds do not exhibit bond-picking abilities. Our paper is closely related to recent studies on investors preferences for higher-yield securities, particularly in times of easy monetary policies. Becker and Ivashina (2014) are the first to document reaching for yield by insurance companies, by showing that corporate bonds with high yields (relative to their ratings) are purchased to a relatively greater extent by insurance companies, a pattern that is strongest before the 2008 financial crisis. Di Maggio and Kacperczyk (2014) show that money market funds display higher return spreads and higher portfolio concentrations in relatively risky bank obligations when the fed fund rate is low. Hong, Sraer, and Yu (2014) show that when uncertainty regarding future inflation is high, speculative investors have an incentive to hold long-maturity bonds and thus have the effect of pushing the long end of yield curves down. We add to this line of studies by documenting the extent to which corporate bond funds prefer bonds with higher yields in a low-interest-rate environment. Our paper also adds to the large body of literature on mutual fund incentives and risk-taking behaviors. For example, Brown, Harlow, and Starks (1996), Chevalier and Ellison (1997) and Chen and Pennacchi (2009), among many others, show that risk-taking by funds is driven by incentives. Goetzmann, Ingersoll, Spiegel, and Welch (2007) show how mutual funds can manipulate performance measures. Sensoy (2009) presents evidence that funds use self-designated indices to beat benchmarks and attract more flows. A closely related paper is Huang, Sialm, and Zhang (2011), who use fund-level holdings data by equity mutual funds to show that excess risk-taking by these funds has a negative impact on their performance. 6 Similarly, Kacperczyk and Schnabl (2013) examine risktaking by money market funds during the financial crisis and show how their risk-taking affected outflows from those funds. Finally, Christoffersen and Simutin (2014) show that increases in the fraction of equity mutual funds assets that come from Defined Contribution plans are followed by an increase in risk-taking by these funds, but that the increase in risk-taking does not negatively affect risk-adjusted performance (alpha).

14 Asia-Pacific Journal of Financial Studies(AJFS) CAFM 2015 The 10 th International Conference on Asia-Pacific Financial Markets

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30 Special Issue of Asia-Pacific Journal of Financial Studies on Corporate Finance in the Global Economy: Value Creation via Innovations Special Issue Editor: Yong H. Kim University of Cincinnati Asia-Pacific Journal of Financial Studies (AJFS) Investment in human capital and firm value Corporate entrepreneurship and financial performance Global competition and corporate governance Corporate ownership, control and organizational changes and value creation Globalization and capital budgeting, corporate finance and the cost of capital Financial market integration and corporate financial policy Cross-border joint ventures, alliances, M&As, outsourcing and boundaries of firms Corporate risk exposure and management in capital budgeting and financing decisions Corporate finance and portfolio allocation strategies Effects of globalization on financial constraints and investment Effects of macroeconomic and financial crises on corporate finance Financial liberalization and corporate finance Emerging market multinationals and corporate governance Political economy of culture, law, institution, and governance in corporate finance Financial innovations and corporate finance Behavioral issues related to firms and investors in corporate finance Corporate cash holdings and firm value Welfare consequences of financial globalization and corporate finance AWARDS: SUBMISSION INFORMATION:

31 The Tenth Annual Conference on Asia-Pacific Financial Markets (CAFM) of the Korean Securities Association (KSA) Seoul, Korea, December 5, 2015 KEYNOTE SPEAKER: ELECTRONIC SUBMISSION: BEST PAPER AWARDS: Asia-Pacific Journal of Financial Studies (AJFS) BEST DISSERTATION AWARD: PAPER STYLE: CONTACT:

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