The financial market crisis of 2008-2009 involved domino-like liquidity shocks that regulators including the Federal Reserve Bank and the Securities and Exchange Commission don’t want to see repeated. Finance professors Kumar Venkataraman and Pab 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.
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, regulations that increase bank capital requirements and restrictions on speculative trading have reduced traditional bond dealers’ willingness to serve as liquidity providers. Thus, bond investors could have difficulty selling, resulting in market dysfunction.
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 authors show that a new breed of liquidity supplier has emerged — bond mutual funds, an important buy-side investor.
Bond mutual funds and exchanged-traded funds have more than doubled their assets under management from 7.3 percent in 2006 to about 18 percent in 2016. According to the research, from 2003-2014, the average bond fund demanded liquidity from bond dealers, the effect was when markets were stressed.
Venkataraman and Jotikasthira show that a new breed of liquidity supplier has emerged — bond mutual funds, an important buy-side investment.. The bond mutual funds that exhibit a liquidity-supplying trading style are able to obtain better returns for investors in their funds. 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,” says Venkataraman. In a low interest rate environment, where investors and retirees are earning very little in bond portfolios, the ability to earn investment returns by supplying liquidity is particularly attractive for fund investors.
Corporate bond trades 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.
According to Jotikasthira, “Our research can potentially be generalized to other buy-side institutions, such as insurance companies and pension funds.” Venkataraman adds, “Based on our evidence, about 15 to 20 percent of corporate bond funds are exhibiting the trading style of a liquidity supplier. We find that this trading style is related to future fund outperformance.”
Industry participants working on next generation electronic trading platforms find the author’s research highly informative.
Based on the evidence, about 15 to 20 percent of corporate bond funds are exhibiting the trading style liquidity supplier.
Evidence indicates that some bond funds have been implementing this trading style since the start of the study period in 2003. Venkataraman says, “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.”
Venkataraman and Jotikasthira, with Amber Anand of Syracuse University, co-authored the working paper titled, “Do Buy-Side Institutions Supply Liquidity in Bond Markets? Evidence from Mutual Funds.”