Informed trading in government bond markets

Abstract

Using comprehensive regulatory data, we examine trading by different investor types in government bond markets. Our sample covers virtually all secondary market trading in gilts and contains detailed information on each transaction, including the identities of both counterparties. We find that hedge funds' daily trading positively forecasts gilt returns in the following one to five days, which is then fully reversed in the following month. A part of this short-term return predictability is due to hedge funds' ability to anticipate future demand of other investors. Mutual fund trading also positively predicts gilt returns, but over a longer horizon of one to two months. This return pattern does not revert in the following year and is partly due to mutual funds' ability to forecast changes in short-term interest rates.

OTC Discount

“…Information is often revealed via order flow. Czech et al (2021) show that the order flow by hedge funds and mutual funds predicts bond returns in the UK Gilt market, and Ranaldo and Somogyi (2021) present similar findings for the FX market. These results are consistent with Grossman (1992) where information need not necessarily be about fundamental value but can also refer to expressed and unexpressed order flow.…”

“…Informed trading is often associated with realized returns. We follow the literature on informed trading in bond markets (Czech et al, 2021) to assess whether the information content of trades can explain the pecking order of transaction costs that we have documented. Specifically, we regress bond returns on order flows in each protocol as follows:…”

“…For safe and highly liquid assets such as Bunds, this is likely to be the relevant information to which dealers have access. In the Gilt market Czech, Huang, Lou and Wang (2021) show that some customers' order flows carry information on future returns. We complement this finding by showing that in the interdealer Bund market order flows via both the exchange and brokers predict future returns, reflecting the informedness of these flows.…”

Informed Trading and the Dynamics of Client-dealer Connections in Corporate Bond Markets

“…To test the informational role of connections, we first estimate whether the order flow initiated by clients with above-average connection levels can predict future bond returns. Building on Czech, Huang, Lou, and Wang (2020), we proceed in four steps. For each client, we first sort trading days into two buckets depending on whether the given client had more or fewer connections on a given day compared to her sample average.…”

“…For each bond/day combination, we measure the number of connections separately for sophisticated as well as nonsophisticated investors. Consistent with our previous classification, we consider asset managers and hedge funds as sophisticated investors; and classify non-dealer banks, insurers and pension funds as non-sophisticated investors (see also Czech, Huang, Lou, and Wang, 2020). We estimate the following daily panel regression:…”