By Simon Jessop
LONDON (Reuters) - European corporate bond markets could prove a bigger source of market instability during the next big shock than during the 2008 financial crisis, a study by the Bank of England showed.
The study is the first to try to model how non-bank lenders would react in a stressed market environment, with the BoE particularly concerned about the effect on corporate funding rates and their impact on the real economy.
The need to model the risk has arisen because capital markets have provided a bigger slice of corporate funding since the financial crisis and many of the often-illiquid bonds are held in mutual funds offering daily exits to investors.
With dealers at banks making markets in bonds operating under tougher capital rules and therefore more sensitive to risk than before the crisis, the Bank of England is concerned that they may not be able to absorb panic-selling by investors.
The study found that weekly mutual fund redemptions of 1 percent of assets under management -- a level seen during the 2008 crisis -- could increase corporate bond interest rates for companies with high credit ratings by about 40 basis points.
But the ability of dealers to absorb those sales could be tested if redemptions are only a third higher, in what the study described as "an unlikely, but not impossible, event".
"It is a first -- pilot -- step and so is an incomplete exercise, focusing on one type of stress scenario, one market and simple models of the behavior of important parts of the system," the central bank said in the report.
"Nevertheless, it has allowed a scenario to be explored in which large-scale redemptions from open-ended investment funds trigger sales by those funds, with resulting spillover effects to dealers and hedge funds."
The Bank said it would follow up by examining the role played by pension funds and insurance companies, and would feed into work carried out by peers globally. The results could inform future policy action, though none was recommended.
Asset management companies have long argued that they are safe individually and not in need of stress tests such as those in the banking sector because the risk of losses is contained within a fund and borne by investors alone.
The Bank of England agreed with that assessment but said the study showed how changes in market structure, coupled with investors' tendency to sell into a falling market, could create a feedback loop between individually safe parts of the market that amplified the shock.
(Reporting by Simon Jessop and David Milliken; Editing by David Goodman)