Why More Turnover Can Raise the Cost of Holding a Bond

The corporate-bond market can become busier without becoming cheaper to own. This chapter examines how the shift toward mutual funds and ETFs is represented in the model—not as a new trading platform, but as more frequent changes in customers' desire to hold the bond. Following those changes from an ownership shock to a buy or sell order, a dealer match, and a new holding state shows why liquidity compensation can rise while voice and electronic bid-ask spreads remain nearly flat.

Ownership changes are not the same as turnover

The composition of corporate-bond ownership has changed substantially. The paper reports that mutual funds and ETFs held 9.5% of corporate and foreign bonds in 2000Q1 and more than 20%, or 23%, by the second quarter of 2025, while the share held by life insurers and pension funds fell from 41% to 32%. These figures describe who holds the assets. They do not, by themselves, tell us how often those assets are traded or how much demand arrives at a dealer on a particular day.

The model's contribution is to connect the ownership story to a specific trading mechanism. It represents the move toward more active vehicles through a higher arrival rate of customer preference shocks. A preference shock is a new draw of how valuable it is for a customer to own the bond. When the draw changes, the customer's desired holding can change even though the bond itself and the competitive inter-dealer price have not.

This is a deliberately compressed representation. Mutual funds and ETFs can trade in response to benchmark flows, index reconstitutions, creation and redemption activity, performance, or broader portfolio decisions. The model does not create a separate state for each reason. It uses one frequency parameter to capture the common consequence relevant to the market: customers reach a buy or sell state more often. Ownership composition supplies the economic motivation; preference-shock intensity supplies the modeled channel.

That distinction prevents two opposite mistakes. It would be too strong to say that a larger mutual-fund or ETF share mechanically causes a particular yield change, because the model does not separately estimate every behavior of every vehicle. It would also be too weak to treat ownership as a static label that has no consequences for dealers. If a larger group of owners rebalances more frequently, the market is asked to provide immediacy more often, and that changes the order flow dealers must handle.

The relevant lifecycle begins with a customer's current holding state. An owner has the bond and receives a convenience yield from it. If a new draw makes ownership less valuable, the owner becomes a potential seller. A non-owner who receives a high enough convenience yield becomes a potential buyer. Neither desire is yet a trade. The customer must still search for a dealer in the correct inventory state, and the dealer must decide whether the opportunity is feasible.

A successful sale transfers the bond from the customer to a dealer with balance-sheet space. A successful purchase transfers it from an inventory-holding dealer to the customer. Each completed transition changes the state available to the next participant. A higher shock frequency therefore does more than increase a count of transactions. It makes the market cycle through holding states more rapidly, creating more occasions on which dealer inventory and capacity must be in the right place.