The Rise of Institutional Investors in Bond ETFs

Abstract

We examine the effect of bond Exchange‐Traded Funds (ETFs) on corporate bond liquidity. Using Propensity Score Matching and Difference‐in‐Differences techniques, we demonstrate that inclusion in ETFs is associated with a 10% reduction in transaction costs for high yield (HY) bonds and 4% reduction for investment grade (IG) bonds. The result holds during periods of market stress and is robust to different liquidity metrics. We find evidence that HY mutual funds use ETFs to manage their liquidity needs, contributing to the steady growth of HY bond ETFs. Increased HY ETF institutional ownership channels trading away from the underlying corporate bonds to the ETF shares and decreases bond aggregate liquidity, although in the cross‐section inclusion in ETFs improves liquidity. IG investors are not substituting ETF trading for bond trading and we conclude that the gains to liquidity accruing to ETF bonds in that market are a net benefit to investors.