Does Mutual Fund Illiquidity Introduce Fragility into Asset Prices? Evidence from the Corporate Bond Market

Open-end mutual funds have grown to become a key player in the corporate bond market. They invest in illiquid bonds but provide liquid claims to shareholders. Does such liquidity transformation introduce fragility to the corporate bond market? To address this question, we create a novel measure of latent fragility in individual corporate bonds based on the asset illiquidity of their mutual fund holders. We find that corporate bonds with higher fragility tend to experience higher future return volatility, after controlling for a rich set of bond characteristics. Moreover, these bonds tend to have more outflows-induced mutual fund selling in the subsequent period. Using the Covid-19 pandemic as a natural experiment, we find that corporate bonds with higher latent fragility at the end of 2019 experienced more negative returns and larger subsequent reversals around March 2020