Knowledge@Wharton: "How Junk Bond Funds Can Be an Early Economic Indicator"

If you've recently found yourself thinking "I just don't have enough numbers to keep track of", here's another..

From K@W, Sept. 4:

There is a new leading indicator that uses intra-family flows into high yield — or junk — bond mutual funds to foresee credit-market overheating, which typically precedes economic downturns. Research by Wharton finance professor Itay Goldstein, and co-authors Azi Ben-Rephael and Jaewon Choi, uses their model to also predict the business cycle by forecasting GDP growth and unemployment — up to one year earlier than other indicators.

“It’s the first study that links the credit markets to flows in mutual funds,” Goldstein noted. The paper is titled, “Mutual Fund Flows and Fluctuations in Credit and Business Cycles.” He discussed the highlights of the study with Knowledge@Wharton. (Listen to the full podcast above). 

An edited transcript of the conversation follows.

Knowledge@Wharton: There are a lot of studies out there, as you note in your paper, linking the business cycle to credit markets. One broad conclusion that you note — from the literature — is that growth and leverage in the financial sector combined with negative shocks leads to financial crises. The upshot in your paper is that while an overheating of credit markets typically precedes an economic downturn, a big question remains: Is there a way to know when overheated credit conditions are likely to develop before they actually develop, and if so, then the government might be able to take some action to blunt a possible downturn.
Please give us a short overview of what you have identified in the paper.

Itay Goldstein: As you note, the credit market is cyclical and it tends to be correlated with the economy as a whole. We tend to see that credit market is overheating before a downturn in the economy. And many scholars in finance and macroeconomics are trying constantly to find why this is the case, and also to find leading indicators to tell us when it is coming. People have looked at [mostly equity] mutual funds over the years, but did not find quite the right signal coming out of mutual funds that will tell us sort of a leading indicator for the credit cycle.

And we identified what we think is a good leading indicator, and this is flows into high yield corporate bond funds. But not just flows. What we have is a particular component of flows, which is the intrafamily flows into high yield corporate bond mutual funds [that occurred between January 1984 and December 2012].

… Our leading indicator has really two components. First it looks at interfamily flows, and then it looks at flows into high yield funds. Let me first talk about the interfamily aspect of it. The ICI, the Investment Company Institute, publishes data on flows in general across different funds, different types of funds, and also gives us information as to what flows are within the family, and what flows are outside of the family. When I say outside of the family it means money flowing into the fund family and out of the fund family.

“We identified what we think is a good leading indicator, and this is … intrafamily flows into high yield corporate bond mutual funds.”

So a fund family is something like Vanguard for example. So Vanguard is a fund family because they have many funds, and they are all under the big umbrella of Vanguard. And Vanguard would have corporate bonds, government bonds, equity, high yield bonds, investment grade bonds and so on.

And what we look at is flows within Vanguard into the high yield funds. And basically what we find is that when you look overall across all families, the intrafamily — the within-family flows into high yield bonds — are highly predictive.

Now why is that the case? So why should we care about the intrafamily component? Because we think that this is the first component to move, to show signs of changes in demand for risk, for changes in taste, for investment. Think about it, when investors have money in Vanguard or other fund families, and all of a sudden they have, say, a greater appetite for risk, they want to invest in high yield bonds. The first thing they will do is take money they already have invested in other funds of this family, and move it towards the type of fund that they are interested in.

And we think that this is why the intrafamily flows into high yield funds is the thing that is the most effective leading indicator. Because when something changes in underlying tastes, in capacity for risk, and appetite for risk, the first thing that will move, that will show signs of changes, will be the flows within the family towards that type of investment.

Knowledge@Wharton: So when you talk about those interfamily flows, you refer to them as the smart money. And I guess in this case, it doesn’t necessarily mean they are correct, it means that they are sophisticated investors who tend to move faster than others. … So how does focusing on that then get you to predict these other macroeconomic markers?

Goldstein: It has been noted before that the credit market is correlated with the economy. When there are signs of overheating in the credit market, generally it is correlated with contemporaneous, good economic conditions — high GDP, low unemployment. But then it leads later on to worse economic conditions.

“It’s the first study that links the credit markets to flows in mutual funds.”

… An overheated credit market would be one where credit spreads tend to be low, there is high volume of issuance of bonds — the share of high yield bonds out of overall bonds is generally high. Financial intermediaries are going to expand their balance sheets. So all of these indicators generally point to potentially overheated credit markets.

… But then it also predicts a downturn. So, how is all of this related to mutual fund flows? Basically what many researchers are trying to find out is, what are the origins of these credit market conditions, or credit market overheating.

We think that it originates from some change in demand by investors. Investors all of a sudden have maybe a more positive outlook for the economy, they have greater appetite for risk, and as a result they shift their investments towards the high yield funds, the high yield bonds. But the challenge is really to identify this signal coming out of market data. And what we found is that looking at this component of intrafamily flows into high yield funds is really an indication of this buildup of demand, and greater appetite for risk.

This predicts the improving conditions in the credit markets potentially overheating, and then leading to the downturn in the economy. So I am not trying to say that these flows within the family of mutual funds into high yield bonds are causing the whole thing, but they are just an indicator that within the economy people start building this appetite for risk, and want to invest in these high yield bonds. This is a clean indicator that this is happening. And then for us, researchers looking at that, it helps us predict the things that are about to come.

Knowledge@Wharton: What you have found seems to be an earlier indicator than anything else that is out there right now.

Goldstein: Right. Other indicators have been offered before, for example, the high yield share, which is the share out of total bond issuance that is coming out of high yield. Our indicator leads that by a year or even more. Another indicator that has been proposed is the excess bond premium — basically, the premium on bonds that is not coming from credit risk. And again, ours leads that by a few quarters. So basically it is a leading indicator that seems to predict all of the other leading indicators that have been offered in the literature....MORE