The over-the-counter structure of the corporate bond market makes the value of bilateral interactions particularly important for investors. For clients, an established dealer relationship can let the client buy or sell bonds more easily and cheaply. For dealers, a client relationship could be helpful for managing inventory risk, for generating larger profits from loyal clients, or for extracting information from the client’s order flow. Such relationships may be particularly valuable during stress episodes like the March 2020 Covid-19 crisis. In this paper, we use a unique regulatory data set on corporate bond transactions to study bilateral trading relationships in the dealer-customer segment of the corporate bond market.
Our data set contains information about the identities of the traders, which allows us to dig deeper into the drivers of relationships by exploring a rich cross section of client types. We formulate three hypotheses that could explain why relationships matter for dealers and test them in the data. Our contribution is to show that clients’ liquidity provision and the management of costly balance sheet space can help to explain why dealers value relationships with certain clients and quote them better prices. We show that relationship clients generate the bulk of dealers’ trading profits, suggesting a strong incentive for dealers to keep high-value clients as customers.
Our results show that clients with a strong relationship with a dealer face a sizeable 51% reduction in transaction costs relative to the median client, which maps to total annual savings of around £1.3m in transaction costs for the average top relationship client. We find the decrease in transaction costs to be particularly important during stress times when the relationship discount more than doubles. We find evidence that dealers use relationship discounts to help control their inventories and that clients who regularly help dealers in this way receive larger discounts. We also find evidence that dealers give relationship discounts in order to retain clients such as asset managers that generate the bulk of dealers’ profits. We find no evidence that dealers give discounts to clients from whom they can learn private information.
We find that clients with stronger past trading relationships with a dealer receive consistently better prices in corporate bond trading. The top 1% of relationship clients enjoy transaction costs that are 51% lower than those of the median client – an effect which was particularly beneficial when transaction costs spiked during the COVID-19 turmoil. We find clients’ liquidity provision to be a key motive why dealers grant relationship discounts: clients to whom balance-sheet constrained dealers can turn as a source of liquidity are rewarded with relationship discounts. Another important motive for dealers to give discounts to relationship clients is because these clients generate the bulk of dealers’ profits. Finally, we find no evidence that extraction of information from clients’ order flow is related to relationship discounts.
JEL classification: G12, G14, G23, G24
Keywords : corporate bonds, Covid-19, dealers, over-the-counter markets, trading relationships