Do Mutual Funds and ETFs Affect the Commonality in Liquidity of Corporate Bonds?

Abstract

The paper studies the effect of growing mutual fund and ETF ownership on the commonality in liquidity of underlying bonds. Unpredictable liquidity needs of funds may give rise to correlated trading across underlying illiquid bonds. I document that there is a positive and significant relationship between ETF ownership and liquidity commonality of investment-grade bonds suggesting that ETFs reduce the possibility to diversify liquidity risk. In contrast, and unlike for equities, mutual fund ownership does not affect the co-movement in liquidity of bonds. I show that three channels explain the differential impact of ETFs and mutual funds: flow-driven correlated trading, different investor clienteles, and ETF arbitrage activity.