Flow-Induced Trading: Evidence from the Daily Trading of Municipal Bond Mutual Funds

Abstract

We use novel data on daily trading and cash of open-end municipal bond funds to study the dynamics of flow-induced trading. Daily regressions reveal much stronger short-term reliance on cash than suggested by monthly data. The effect of liquidity buffers is nonlinear and depends strongly on their composition. Flow-induced sales decrease with average markups and increase with expected future aggregate outflows. We estimate that a mandatory 10% liquidity buffer would have significantly reduced sales during the COVID-19 pandemic, but the effects depend strongly on buffer composition and whether funds are permitted to use liquidity buffers for bond purchases.

Keywords: fire sales, mutual fund flows, municipal bonds, liquidity management, daily trading

JEL Classification: G11, G12, G23