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Regulators of financial markets, including the Federal Reserve Bank and the Securities and Exchange Commission, worry about a liquidity crisis in the corporate bond market. The financial market crisis of 2008-2009 involved domino-like liquidity shocks and regulators wish to steer clear of them if they can help it. In new research, ������˾��Cox Finance Professors Venkataraman and Jotikasthira show that some bond mutual funds are filling the role of a liquidity supplier, alongside a decline in dealer participation in market-making activities.

The size of the corporate bond market has grown from $4.8 trillion in 2006 to $8.5 trillion in 2016. A recent Economist articles cites that firms issued just under $200 billion worth of equity shares and $1.5 trillion worth of bonds in 2016, attesting to the trend.

Banks have largely been the go-to bond dealers that market participants counted on to provide liquidity and for completing their trades. Liquidity is the ability to buy and sell one's holdings in a timely manner. Since the financial crisis, regulation that increases bank capital requirements such as the Basel Rule and restrictions on speculative trading activities like the Volcker Rule have reduced bond dealers' capabilities or willingness to serve as liquidity providers. Thus bond investors could have difficulty in selling bonds that they wish to unload.

In a period of rising interest rates and falling bond prices this could become a big problem for the market, with the possibility that more sellers than buyers demand liquidity from bond dealers. The dealers would not be there to absorb the order flows from the bond investors. At the same, since bond mutual funds promise daily liquidity to mutual fund investors, this could lead to the possibility of a panic run on a mutual fund, if it is unable to meet its stated obligation to redeem fund shares.

According to the research, a new breed of liquidity supplier has emerged — bond mutual funds that are an important category of buy-side investors. Bond mutual funds and exchanged-traded funds have doubled their assets under management from 7.3% in 2006 to about 18% in 2016. According to the research, during 2003-2014, the average bond fund demands liquidity from bond dealers, and the effect is stronger when markets are stressed.

The fixed income market is very different from the equity market, notes Venkataraman. "In equity markets, it is relatively easy to find a counterparty in an organized exchange and the ability to complete a trade is not cumbersome," he says. "The fixed income market is akin to the used car dealer market of about 20 years ago, where the car dealer is involved in virtually every transaction." The big dealers in the fixed income market are commercial banks, which have been identified by regulators to be systemically important institutions. Since some bank activities and types of trading were considered speculative, adding elements of systemic risk to the broader economy, the activities of banks have been curtailed by market regulators after the crisis. When the dealers curtail their market making activities, it has a visible impact on bond liquidity and creates a mismatch between buyers and sellers.

The study

A significant contribution of the research is that buy-side institutions, specifically bond mutual funds, are identified as an important source of liquidity supply in bond markets. Further, the subset of bond mutual funds that exhibit a liquidity-supplying trading style are able to obtain better returns for the investor in their particular mutual fund. The study categorizes trading style based on "when institutions choose to implement their trades, rather than on what they choose to hold in their portfolios," notes Venkataraman. In a low interest rate environment, where investors and retirees are earning very low yields in bond portfolios, the ability to earn investment returns by supplying liquidity is particularly attractive for fund investors.

The authors also note that trades in corporate bonds can be completed more easily with the participation of mutual funds since traditional bond dealers are less willing to accommodate the customer's desire to buy or sell quickly. Jotikasthira says the market does not observe this “immediacy” but it is an important dimension of liquidity. In a well-functioning market, the ability to buy and sell securities when desired increases the "social welfare" of market participants.

A contrarian style is the best way to characterize the trading style of the bond funds highlighted in the study, notes Venkataraman. "A bond fund that is buying when everyone is selling and selling when everyone is buying is effectively trading against the aggregate order imbalance," he explains. "It has a contrarian participation style which is the hallmark of liquidity supply."

Additionally, the study shows that the ability for a bond fund to supply liquidity depends on the composition of investors in the bond mutual fund. Some funds were found to be handicapped by volatile investor flows that force costly trading. Patient fund investors are the hallmark of liquidity supplying bond funds. In order to implement a liquidity-supplying trading style, a bond fund needs a certain amount of cash or liquid bonds in its portfolio, and less skittish fund investors.

Bond mutual funds facing potentially daily inflows and outflows trade more frequently than insurance companies and pension funds, and hence incur significant transaction costs. Transaction costs in bonds markets are higher than equity markets. Jotikasthira mentions, "While our research specifically examines the role of bond mutual funds as liquidity suppliers, it can potentially be generalized to other buy-side institutions, such as insurance companies and pension funds."

"Based on our evidence, about 15-20% of corporate bond funds are exhibiting a trading style as a liquidity supplier," says Venkataraman. "We find that this trading style is related to future fund outperformance." Fund alphas, or excess returns, are around 4.5 basis points per month, or around 0.60 percent annually; however the strategy payoffs depend on market conditions. During the financial crisis of 2008-09, the excess return attributable to the trading style averaged 12.6 basis points per month. In other words, funds that leaned into the storm earned significant compensation for doing so.

Based on study period data from 2003-2014, the majority of bond funds have a liquidity demanding style of trading. "Not every fund can trade in the liquidity provision style we have identified in the research," notes Jotikasthira.

In future

Those in the financial industry working on next generation bond electronic trading platforms have shown interest in the authors' research. Venkataraman offers, "Our evidence is showing electronic platforms that they can gain an advantage over competing platforms by inviting buy-side institutions to compete with bond dealers for liquidity provision." Interestingly, the rise of bond funds as influential players "do seem to pose a competitive threat" suggests Jotikasthira. He likens their emergence to peer-to-peer lending and crowd-sourced equity research.

When asked about whether this liquidity-supply trading style is more novel in recent times owing to the financial crisis, Venkataraman and Jotikasthira suggest not. Evidence in the data indicates that some bond funds have been implementing this trading style since the start of the study period in 2003. This trading style is more relevant because "while the bond market has seen explosive growth in issuance, the bond dealers have been reducing inventories, and this points to a looming liquidity problem when markets become volatile," says Venkataraman.

Some mutual funds are stepping up to the challenge in the bond market and " receiving rents for their fund investors," Venkataraman adds.

The working paper "Do buy-side institutions supply liquidity in bond markets? Evidence from mutual funds" is authored by Kumar Venkataraman and Chotibhak Jotikasthira of the Cox School of Business, ������˾�� and Amber Anand of Syracuse University.

Written by Jennifer Warren.