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

Author

Listed:
  • Yi Li

    (Board of Governors of the Federal Reserve System, Washington, DC 20551)

  • Maureen O’Hara

    (Johnson College of Business, Cornell University, Ithaca, New York 14853)

  • Xing (Alex) Zhou

    (Cox School of Business, Southern Methodist University, Dallas, Texas 75275)

Abstract

Against the backdrop of COVID-19, we study how the interactions of mutual funds and dealers introduce fragility to the municipal bond market and induce lasting market 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.

Suggested Citation

  • Yi Li & Maureen O’Hara & Xing (Alex) Zhou, 2024. "Mutual Fund Fragility, Dealer Liquidity Provision, and the Pricing of Municipal Bonds," Management Science, INFORMS, vol. 70(7), pages 4802-4823, July.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:7:p:4802-4823
    DOI: 10.1287/mnsc.2023.4912
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