Mutual Fund Trading Style and Bond Market Fragility

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

Year of Publication : Review of Financial Studies (forthcoming)

Summary of Findings : A subset of mutual funds intentionally supply liquidity in corporate bond markets during periods of sustained customer selling, even when facing large outflows and elevated market stress, thus alleviating fragility risk.

Research Questions : Do buyside institutions supply liquidity in corporate bond markets?
Do they supply liquidity during periods of market fragility?
Does their trading alleviate fragility risk?

What we know : Unlike equity funds, poor performance leads to large investor outflows from bond funds, raising concerns about price destabilizing effects of funds selling relatively illiquid assets to meet redemption needs.

The stability risks posed by liquidity demand from funds are heightened in light of recent evidence that post-crisis banking-related regulations, such as Volcker Rule, have reduced dealer capital for market making in fixed income securities.

Regulators are concerned that incidents of institutional selling coupled with reductions in the supply of dealer capital can potentially amplify the fragility risk of the bond market.

Novel Findings : A liquidity supplying trading style contributes positively to fund alpha, reflecting a premium for liquidity supply when bonds face selling pressure.

While prior work concludes that mutual funds pose a threat to market stability, our study is the first to show that a subset of funds could potentially help alleviate the fragility risk of the bond markets.

Novel Methodology : We provide a new method to capture bond illiquidity by building dealer inventory cycles, and use these inventory cycles to classify fund trading style. Given bond illiquidity, the slow-moving inventory cycles present an accurate picture of liquidity conditions in a bond. The cycle-based classification is also better in a context where fund positions are only observed monthly or quarterly.

Implications for Practice : A liquidity supplying trading style can enhance fund performance. Funds can evaluate if liquidity supply fits within their investment strategies.

Implications for Policy: Our study highlights buy-side institutions as an important liquidity source and a potential solution to the fragility concerns in the corporate bond market. In light of regulatory changes that caused a decline in dealer capital for market making, the bond markets could benefit from liquidity supply by other types of participants. To tap into, and further encourage, the channel of liquidity supply that we identify, regulators need to remove frictions (for example, the market power exercised by large players in OTC markets) that impede broad participation by institutions. In particular, designers of trading systems need to offer protocols that provide institutional and retail investors with direct access to platforms (e.g., MarketAxess’ Open Trading platform) and the ability to post limit orders that compete with dealer quotations.

Full Citations : Anand, A., C. Jotikasthira, and K. Venkataraman, 2020, Mutual Fund Trading Style and Bond Market Fragility, Review of Financial Studies, forthcoming.

Abstract : We explore the link between mutual funds and fragility risk in the corporate bond market. We classify a fund’s trading style based on its responses to signals of large dealer inventories. Trading style is persistent and the majority of funds demand liquidity. Notably, a subset of funds earn positive alpha by intentionally supplying liquidity during periods of sustained customer selling (with transitory price effects). Liquidity supplying funds maintain their relative trading style when facing large outflows and elevated market stress, thus alleviating fragility risk. Our results add nuance to existing evidence that mutual funds pose a threat to market stability.

A subset of mutual funds intentionally supply liquidity in corporate bond markets during periods of sustained customer selling, even when facing large outflows and elevated market stress, thus alleviating fragility risk.

Amber Anand
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