Chotibak Jotikashtira (Southern Methodist University)

Intermediary Balance Sheet Constraints, Bond Mutual Funds’ Strategies, and Bond Returns

Abstract: We show that after the introduction of the leverage ratio constraints on bank-affiliate dealers, bond mutual funds have engaged in more liquidity provision in investment-grade corporate bonds, and their performance has benefited. However, the liquidity and returns of investment-grade corporate bonds have become more exposed to aggregate outflows from the bond mutual fund industry. This suggests that the inability of bond funds to purchase bonds exposed to leverage constraints impacts market functioning. We show that mutual funds’ missing liquidity provision helps explain which bonds experienced more severe deterioration in liquidity and returns at the onset of the COVID-19 pandemic.