Nº 20-81: Do Mutual Funds and ETFs Affect the Commonality in Liquidity of Corporate Bonds?

The paper studies the effect of demand-side sources on the commonality in liquidity of corporate bonds as the growing mutual fund and ETF ownership in the corporate bond market may give rise to correlated trading across bonds. I document that there is a positive and significant relationship between ETF ownership and liquidity commonality of investment-grade corporate bonds. In contrast, and unlike for equities, I find that mutual fund ownership does not increase commonality in liquidity of corporate bonds. I show that three different channels explain the differential impact of ETFs and mutual funds on liquidity commonality: flow-driven trading, different investor clienteles, and ETF arbitrage mechanism.