Do mutual funds and ETFs affect the commonality in liquidity of corporate bonds?

Abstract

This paper explores the influence of increasing ownership in fixed-income ETFs and mutual funds on liquidity commonality among corporate bonds. The unpredictable nature of liquidity demands in these funds may lead to correlated trading in underlying illiquid bonds. The study finds a positive and significant relationship between ETF ownership and liquidity commonality in investment-grade corporate bonds. In contrast, mutual fund or index fund ownership does not exhibit a similar effect, a result that differentiates corporate bonds from equities. This distinction from equities is attributed to different liquidity management strategies employed by equity and corporate bond mutual funds. The paper also highlights factors contributing to the varying impacts of ETFs and mutual funds on corporate bonds, including correlated trading due to fund flows, differences in investor clienteles, and the role of ETF arbitrage activities.