The Fragility Tax: How Mutual Fund Ownership Links Segmented Markets 

Abstract

Open-end funds' retail liability structure transmits equity shocks across otherwise-segmented asset classes, producing a structural cost-of-capital wedge in municipal bonds. Bonds held by municipal funds with high stock-market sensitivity trade at yield spreads 14-25 basis points wider than same-issuer comparables, equivalent to a multi-notch credit downgrade. We call this the Fragility Tax. When stocks fall, retail fund investors redeem municipal fund shares, forcing fire-sales priced ex ante. Only direct, liability-driven fund beta predicts yields, ruling out equity-correlated fundamentals. Fickle capital and fund liability structure raise aggregate borrowing costs by $2.5 billion annually, a pecuniary externality on local public finance.

Keywords: Open-end fund fragility, Fire sales, Fragility Tax, Market segmentation, Liquidity transformation, Fickle capital, Pecuniary externality, Municipal bonds

JEL Classification: G23, G12, G28, H74