The Importance of Investor Heterogeneity: An Examination of the Corporate Bond Market

Abstract

Corporate bond market participants are increasingly worried about liquidity. However, bidask spreads and other standard measures indicate liquidity has not deteriorated significantly. This paper proposes a potential reconciliation. We show the sensitivity of credit yields to bid-ask spreads increased fourfold from 2005 to 2019. We then provide a model that connects this change to the rapid growth of mutual funds in the corporate bond market. The model features heterogeneous investors with different trading needs who choose between a risk-free asset and illiquid bonds. As the risk-free rate declines, more short-term investors reach for yield and enter the bond market. These short-term investors reduce the selling pressure in each sub-market and so the bid-ask spreads. However, their greater trading needs amplify the sensitivity of credit yields to the bid-ask spreads, leading to a larger liquidity component.We next test the model's predictions using detailed data on investor holdings in the U.S. As predicted, we find investor turnover is associated with larger effects of illiquidity on credit yields. Bonds with more short-term investors are traded at lower bid-ask spreads, but their credit yields are more sensitive to the bid-ask spreads. Finally, we look across countries and show that, consistent with the model, larger declines in risk-free rates are associated with higher growth in mutual fund shares. These results highlight the key role that investor heterogeneity plays in determining how liquidity is priced into corporate bond yields and firms' financing conditions. viii

Dealer costs and customer choice

“…2 We obtain similar findings on the importance of illiquidity for the yield spreads as Li and Yu (2023) and Wu (2023), which worked in coincident and independent papers. Our empirical results are different in some aspects (such as our focus on the BPW and Amihud measures) and they complement their findings.…”

“…Wu (2023) use monthly data, as we do. Li and Yu (2023) uses quarterly data; they find an increase of four times of the coefficient on the bid-ask spread. We find a larger increase in the coefficient on illiquidity using γ and AMD and monthly data.…”