Credit ETFs in Mutual Funds and Corporate Bond Liquidity

We show that high yield (HY) mutual funds own and trade ETFs to manage liquidity needs driven by fund flows, whereas investment grade (IG) funds do not. The use of ETFs by HY mutual funds to manage liquidity shifts some trading away from bonds and into ETFs, which reduces the liquidity of the underlying bonds. This substitution effect outweighs the better-understood inclusion effect, whereby bond liquidity benefits from increased ETF ownership, such that the net effect of ETFs is to reduce HY liquidity. In IG, the substitution effect is not significant and ETFs result in increased bond liquidity.