Essays on price, liquidity, and investors' flow-driven trading in corporate bond markets

Abstract

In the first chapter, I study flight from liquidity in OTC markets. By extending the search-based OTC market model of Duffie et al. (2007), I show that a liquid security can be priced lower, not higher, than an illiquid security during times of distress. The more liquid security is more prone to fire sales because sellers can quickly find buyers of the liquid security. Fire sales can drive the price of liquid security lower than that of the illiquid security if delay in finding buyers is too costly. I also document empirical evidence of flight from liquidity by examining on-the-run and off-the-run corporate bonds of the same issuers and same credit ratings. Consistent with the model, the prices of liquid on-the-run bonds become lower than those of illiquid off-the-run bonds, following liquidity events including periods of severe mutual fund outflows, downgrades of an issuer’s credit rating, and the 2008 financial crisis. In the second chapter, in contrast to well-documented evidence reported in equity mutual fund studies, I find that fund flows have limited impact on corporate bond prices. I attribute this puzzling finding to liquidity management conducted by corporate bond funds. Such funds’ trading is highly sensitive to cash holdings and market liquidity. On average, they keep more than 15% of their assets in cash or cash-like securities and sell only 72 bps of bond holdings for one percent outflows, instead of selling on a one-for-one basis. Thus, flow-driven price pressure is pronounced only for bonds held by low-cash funds.