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

Jian (Jane) Li, Joint Program in Financial Economcis PhD student

Mutual funds have grown to be a significant player in the corporate bond market. Different from the traditional holders (insurance companies and pension funds), mutual funds have much higher trading frequencies in general. This paper studies the effects of investor composition change on the corporate bond market. Empirically, we find that even though the bid-ask spreads have been decreasing over time, the impact of bid-ask spreads on credit spreads have been increasing sharply after the 2008 financial crisis. We build a model with heterogeneous bonds and heterogeneous investors to rationalise the aggregate trends. We then apply the insight of our theory to examine how aggregate liquidity shocks interact with the investor composition. Both the current COVID-19 event and the 2008 financial crisis induce high selling pressure in the bond market, however, the market behaviors are quite different. We explore to what extend can investor composition explain those differences.