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

Abstract

We study the period around the COVID-19 crisis to examine the potential fragility risks posed by mutual funds to the municipal bond market. Induced by unprecedented outflows from muni mutual funds, we show that bonds held by these funds trade substantially more and suffer greater price depressions than bonds not in muni funds. Dealer liquidity provision declines more in these bonds, exacerbating their market conditions. Importantly, such destabilizing effects have reshaped market perceptions on the fragility risks posed by mutual funds even after the normalization of muni fund flows. In the aftermath of the muni crisis, dealers reduce their inventories in bonds held by mutual funds and yield spreads widen notably in these bonds, especially when they are held by mutual funds with greater COVID-19 exposure and less liquid portfolios.