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

Mariassunta Giannetti, Stockholm School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Swedish House of Finance
Chotibhak Jotikasthira, Southern Methodist University (SMU) - Finance Department
Andreas C. Rapp, Board of Governors of the Federal Reserve System
Martin Waibel, Stockholm School of Economics; Swedish House of Finance


We show that after the introduction of leverage ratio constraints on bank-affiliated dealers, bond mutual funds have engaged in more liquidity provision in investment-grade corporate bonds and that the performance of funds with liquidity-supplying strategies has benefited. Not only have regulations transferred profits associated with liquidity provision in the corporate bond market to mutual funds, but the liquidity and returns of investment-grade corporate bonds have become more exposed to redemptions from the bond mutual fund industry, suggesting that the regulations may have made investment-grade corporate bonds more volatile. Accordingly, we observe that investment-grade corporate bonds more exposed to leverage ratio constraints experienced more severe deterioration in liquidity and returns at the onset of the COVID-19 pandemic.