Bank rules shift bond market tasks to mutual funds

Corporate bond markets are changing due to regulations imposed after the 2007 to 2009 financial crisis. New research from Southern Methodist University Cox School of Business Professor Chotibhak Jotikasthira indicates that these rules have reduced the ability of banks to provide liquidity. This shift has placed a greater burden on bond mutual funds. The study suggests this transition introduces new fragility into the market structure.

The regulatory change centers on the leverage ratio, a component of Basel III reforms. This rule requires banks to maintain a specific amount of capital relative to their total assets. Jotikasthira notes that the rule does not account for the risk level of the assets held. For example, a bank must hold ten dollars in capital for every one hundred dollars invested, whether the investment is in safe Treasury bonds or riskier assets. This requirement makes it more expensive for banks to hold corporate bonds in inventory.

As a result, banks are altering their role in the market. Instead of buying and holding bonds to sell later, they now act primarily as matchmakers. They connect sellers with buyers, often bond mutual funds, for a fee. Jotikasthira explains that this change means banks are no longer the primary liquidity providers. The responsibility for providing liquidity has shifted to these funds. This shift is evident in trading activity and market shares over the last decade.

The share of corporate bonds held by mutual funds has increased substantially. In 2010, these funds held between 10% and 15% of the market. By 2026, that share has grown to between 20% and 25%. Insurance companies remain the largest institutional holders, but their behavior differs from mutual funds. Insurers typically hold bonds until they mature to match long-term liabilities. Mutual funds, however, trade frequently to track indices and generate returns for investors.

This difference creates a structural problem during periods of market stress. Mutual funds are mostly open-ended, meaning investors can redeem their shares on a daily basis. Corporate bonds, however, are highly illiquid and difficult to sell quickly. Jotikasthira points out that when investors redeem shares rapidly, funds may need to sell bonds to meet those demands. If the market is already stressed, selling bonds becomes expensive and difficult, potentially exacerbating the stress.

The 2020 pandemic provided a real-world test of this dynamic. The research found that bonds held by mutual funds with strained liquidity due to investor outflows experienced a larger increase in trading costs. Other bonds did not see the same spike in costs. This finding confirms that the liquidity provision role is not being filled as reliably as banks provided it previously. The study also notes that funds engaging in liquidity-supplying strategies have generated higher profits for their investors.

Regulators in the United States and Europe are considering adjustments to the leverage ratio rule. Jotikasthira expects these regulators to grant more exemptions for certain bank sizes. He also points to a structural change already occurring in Europe. There, investors who redeem shares now absorb the trading costs associated with those redemptions. This change aims to reduce the incentive for investors to redeem shares preemptively during times of uncertainty. Such a measure could help limit strategic runs on funds, similar to the dynamics seen during the Silicon Valley Bank crisis.

The paper is titled Intermediary Balance Sheet Constraints, Bond Mutual Funds Strategies, and Bond Returns. It is forthcoming in the Journal of Finance. The authors include Jotikasthira, Mariassunta Giannetti of the Stockholm School of Economics, and Andreas Rapp and Martin Waibel of the Federal Reserve Board of Governors. The research indicates that bond mutual funds will likely continue to grow. This growth is driven largely by retirement savings flowing into 401(k)s and other similar investment vehicles.