Negative externalities of mutual fund instability: Evidence from leveraged loan funds

Abstract

The market for leveraged loans that provide debt financing for risky companies has been on an exceptional growth path over the last decade. With the increased presence of investment funds in this market, however, come increased concerns – namely, whether a sharp rise of redemptions by fund investors could set off a cascade of drops in secondary loan prices and whether these price falls could trigger further redemptions, ultimately fueling a downward price and liquidity spiral? This paper provides evidence consistent with the view that in times of loan market stress, fund flows and loan price returns have been pro-cyclical, i.e., have reinforced each other's movements. Furthermore, fund outflows foster market illiquidity. Importantly, the paper identifies lending by CLOs as a channel through which outflow-induced price dislocations in the secondary market transmit to corporate borrowing, making it harder for leveraged companies to rollover their existing debt exactly at a time when liquidity is needed most (in market downs).