Do Buy-Side Institutions Supply Liquidity in Bond Markets? Evidence from Mutual Funds
50 Pages Posted: 19 Jul 2017 Last revised: 18 Jan 2018
Date Written: November 10, 2017
This study presents new evidence on buy-side institutions as a channel of liquidity supply in the corporate bond market. Using bond transactions data, we aggregate the inventory positions of bond dealers, and identify inventory cycles. We classify a bond fund’s trading style as liquidity supplying (demanding) if the changes in bond holdings exhibit a propensity to absorb (further strain) the aggregate dealer positions. Between 2003 and 2014, bond funds on average tend to demand liquidity; however, trading styles vary across funds and are persistent over time. Funds with higher flexibility in portfolio holdings and less volatile investor flows are associated with liquidity supply. Trading style that is liquidity supplying is associated with higher fund performance implying that bond funds have a market incentive to respond to dealer positions. Our results suggest that bond trading platforms should facilitate participation by buy-side institutions to enhance liquidity.
Keywords: Bond liquidity; buy-side institutions; dealer inventory; mutual funds; fund performance.
JEL Classification: G10; G20
Suggested Citation: Suggested Citation