FINANCE


Mutual Fund Fragility, Dealer Liquidity Provision, and the Pricing of Municipal Bonds


MAUREEN O’HARA PROFESSOR


ROBERT W. PURCELL PROFESSOR OF MANAGEMENT


Samuel Curtis Johnson Graduate School of Management


Cornell SC Johnson College of Business Cornell University


Co-authors • Maureen O’Hara


Management Science, 70, 7, July 2024 LINK TO PAPER LINK TO MAUREEN O’HARA VIDEO


Professor, Robert W. Purcell Professor of Management, Samuel


Curtis Johnson Graduate School of Management, Cornell SC Johnson College of Business, Cornell University


• Yi Li, Board of Governors of the Federal Reserve System, Washington, DC • Xing (Alex) Zhou, Cox School of Business, Southern Methodist University


Summary Over the last decade, open-end mutual funds have become prominent players


in fixed income markets. Tis increasing significance has raised substantial fragility concerns: Because these funds finance illiquid fixed income assets through liquid liabilities, their liquidity transformation could incentivize investors to redeem ahead of others in the face of a negative shock, amplifying withdrawals and aggravating liquidations of the underlying assets. Equally concerning, regulatory reforms introduced after the financial crisis might have adversely impacted liquidity provision in fixed-income markets. By tight- ening capital and liquidity requirements, these regulations likely limit dealers’ market making capacities and discourage their risk taking, both of which are particularly valuable during times of stress.


Against the backdrop of COVID-19, the authors study how the interactions of mutual funds and dealers introduce fragility to the municipal bond mar- ket, with lasting impacts. During the crisis, trading surges, whereas dealers’ liquidity provision plunges for mutual-fund-held bonds, leading to greater price depressions in these bonds. Importantly, the crisis reshapes the market’s perceptions of mutual fund fragility risks, with the aftermath-yield spreads widening significantly more for bonds with greater mutual fund exposures. Such postcrisis pricing effects reflect dealers’ continued reluctance to provide liquidity for mutual fund–held bonds, and they are stronger for bonds whose mutual fund holders are more susceptible to investor runs.


CONTENTS TO MAIN


| RESEARCH WITH IMPACT: CORNELL SC JOHNSON COLLEGE OF BUSINESS • 2024 EDITION


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