The role of ETFs in the corporate bond market : an empirical study of potential impacts of fixed income ETFs on the underlying U.S. corporate bond market

Abstract

Exchange traded funds (ETFs) have become popular investment vehicles in the U.S. corporate bond market. A market that is characterised by over-the-counter transactions, low liquidity and high trading costs, is with ETFs more accessible to retail investors and arbitrageurs alike. The ongoing trend is raising several questions from both academics and practitioners. A stream of recent publications explores how these new, mostly passive investment vehicles are affecting the liquidity, valuations and other aspects of the underlying markets. We set out to investigate the effect of ETFs on the commonality of underlying bonds in the U.S. corporate bond market. In our thesis, we examine if different measures of fixed income ETF activity are explanatory factors of commonalities in bond returns, yields, trading volume and illiquidity. Previous research finds that the turnover of ETF shares influences the commonality of individual securities more compared to other ETF activity measures in the equity market. For this reason, we additionally investigate if ETF turnover carries the same relevance in the corporate bond market. In our empirical research we employ naïve OLS, time series and panel regressions to investigate the relationship between ETF activity variables and corporate bond commonality. We include both time and individual fixed effects and various control variables in the models. Additionally, we conduct robustness tests where we add fundamental factors that are potential drivers of bond commonalities in our time series models. Our empirical findings suggest that there exists a relationship between ETF activity and several commonality measures, indicating that fixed income ETFs may have an influence on the comovement of underlying bonds. In addition, we find turnover to have the most pronounced effect of all the included ETF measures. Implications of ETFs inducing higher commonality could be lower diversification benefits and higher liquidity risk. As fixed income ETFs are experiencing solid growth, further research on their implications is needed.