Bond Mutual Fund Flows, Fund Liquidity, and Broker-Dealer Inventories

Abstract

Some financial supervisors worry that liquidity transformation within the “shadow banking” sector might threaten financial stability. For example, a mutual fund promising overnight liquidity based on illiquid assets (such as corporate bonds) runs the risk of needing to “fire sale” some assets, with potentially deleterious external effects. One protection against this possibility would be a broker-dealer sector that stands ready to stabilize prices by buying (or selling) for its own inventory. I evaluate the extent to which bond mutual funds’ flows are reflected in broker-dealers’ inventories. Although brokers generally trade in the same direction as the mutual funds, high-yield corporate bonds present an exception. Flows out of high-yield bond funds are associated with a significant increase in dealers’ high-yield bond inventories. These results provide further information about how various types of bond mutual funds handle liquidity demands.