The Effects of Portfolio Trading on Corporate Bond Volatility

Abstract

This paper investigates the impact of portfolio trading on corporate bond volatility. Portfolio trading has emerged as an indispensable tool in recent years for the corporate bond market, found to improve liquidity and lower execution costs, but the change to bond volatility from portfolio trading is largely unknown and less studied. Using a within-bond event study on newly issued bonds involved in portfolio trading during 2023-2025, this paper finds an increase in volatility after bonds enter a portfolio trade. This increase in volatility continues to build with time and with increased portfolio trading exposure. The changes to volatility observed supports previous literature’s stance that dealers engage in portfolio trading for liquidity needs and to move large amounts of risk quickly, rather than to conduct informed trading, as the market does not appear to absorb any new fundamental information about the underlying bonds from these trades. The greater fluctuations to bond pricing that occur when bonds are included in portfolio trades may be due to the auction mechanism of portfolio trading having a more competitive environment than the bilateral negotiation of individual trades. However, if portfolio trading is occurring as a result of the bond experiencing higher volatility, then dealers may alternatively be viewing portfolio trading as an appropriate tool for trading bonds in volatile conditions. The 2023-2025 sample used in this paper also refreshes understandings of dealer behavior towards portfolio trading: when it comes to selecting bonds for portfolio trades, dealers prefer bonds in ETFs; once selected, dealers heavily and repeatedly trade these bonds in portfolio trades; new issuance does not deter dealers from including these bonds in portfolio trades.