Dynamic Liquidity Management by Corporate Bond Mutual Funds

Abstract

Corporate bond mutual funds tend to hold illiquid assets but provide liquid claims to their investors. How do they manage liquidity to meet investor redemptions? We show that, during tranquil market conditions, these funds tend to reduce liquid asset holdings such as cash and government bonds to meet investor redemptions, temporarily increasing their relative exposures to illiquid asset classes. During periods with heightened aggregate uncertainty, however, they tend to scale down their liquid and illiquid asset proportionally, thereby preserving the liquidity of their portfolios. This fund-level dynamic management of liquidity appears to impact the broad financial market: flows-induced trades in corporate bonds by these funds during high-uncertainty periods generate price pressures, which precede strong return reversals.

Keywords: Liquidity, Mutual funds, Asset Managers, Corporate Bond Funds, Run risks

JEL Classification: G10, G23