Do buy-side institutions supply liquidity in bond markets? Evidence from mutual funds


Author Information : Amber Anand (Syracuse University)
Chotibhak Jotikasthira (Southern Methodist University)
Kumar Venkataraman (Southern Methodist University)

Year of Publication : Working paper, 2017

Summary of Findings : Some buy-side institutions supply liquidity in the bond markets. The liquidity supplying behavior is associated with fund outperformance, especially in times of market stress.

Research Questions : 1. Do buy-side institutions supply liquidity?

2. What are the characteristics of liquidity supplying institutions?

3. Do liquidity supplying funds outperform liquidity demanding funds?

What we know : Regulatory changes in recent years have raised the concern that banks are less willing to commit capital to act as dealers in the bond markets. Regulators and market participants worry that the reduction in dealer commitment is a risk to the smooth functioning of markets, particularly during times of heightened market illiquidity.

Novel Findings : A frequently discussed alternative is that institutional investors could step in and supplement dealer liquidity provision. Yet, there is little empirical evidence on the propensity of buy-side institutions to serve as liquidity suppliers.

We present new evidence on an important channel of liquidity supply in corporate bonds. Although bond funds on average demand liquidity from bond dealers, there is dispersion in trading style across funds, and some funds employ a persistent strategy of absorbing aggregate dealer demand shocks.

We find that the propensity to supply liquidity is related to significant outperformance by the fund. In terms of economic significance, a one standard deviation increase in the "LS_score" (our measure of a fund's trading style) is associated with future monthly fund alpha of approximately two basis points under normal conditions, and 4.2 basis points under stressful conditions. To put these numbers in context, the average fund alpha (gross of fees) is 3.3 basis points per month during our sample.

Novel Methodology : We propose a new measure of liquidity supply to the literature, and apply it to bond mutual funds. Our measure of trading style captures the propensity of a fund’s trades (measured by changes in its holdings) to further strain the inventory positions of bond dealers (liquidity demanding), or to help lay off dealer risk by absorbing the inventory positions of bond dealers (liquidity supplying). The measure is based on data available to academics, and can be applied to over-the-counter markets.

Implications for Practice : Bond funds' trading style is important for their performance. From the funds' viewpoint, the opportunity to supply liquidity can add to their returns. Investors can use information on trading style in picking funds. This is especially important as a hedge against illiquidity that occurs during times of market stress.

Implications for Policy: Mary Jo White, former Chair of U.S. SEC in 2014 expressed concern that the majority of bond trading platforms are being used primarily to support the traditional dealer model and "provide information on the bonds their participating dealer would like to sell." Consistent with this concern, a 2013 industry study reports that over 70 percent of institutional corporate bond investors expect multi-dealer request-for-quote (RFQ) platforms to dominate. Nonetheless, 45 percent of the larger investors expect crossing networks that involve buy-side firms to play a significant role in the future. One implication of our study is that multi-dealer platforms can significantly expand the liquidity pool, and also facilitate risk sharing for bond dealers, by developing capabilities that allow buy-side institutions with interest in the underlying bonds to receive RFQs, and respond with quotations.

Full Citations : Anand, Amber, Chotibhak Jotikasthira and Kumar Venkataraman, 2017, Do buy-side institutions supply liquidity in bond markets? Evidence from mutual funds. Working paper, Syracuse University and Southern Methodist University

Abstract : 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 bond funds and are persistent over time. Higher flexibility in portfolio holdings is associated with a liquidity supplying trading style. A liquidity supplying trading style earns higher future fund returns after controlling for portfolio attributes and factor risk exposures. These results suggest that trading style contains useful information for investors in selecting bond funds and that bond market liquidity can be enhanced by developing platforms that facilitate participation by buy-side institutions.

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A working paper by Amber Anand, Edward Pettinella Professor of Finance, finds some buy-side institutions supply liquidity in the bond markets. The liquidity supplying behavior is associated with fund outperformance, especially in times of market stress.

Amber Anand

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