Mutual Fund Liquidity Transformation and Reverse Flight to Liquidity
57 Pages Posted: 2 Jul 2020 Last revised: 30 Jul 2020
Date Written: July 29, 2020
We document that traditionally liquid asset markets, such as those for Treasuries and high-quality corporate bonds, experienced significant strains from unusually high selling pressures during the COVID-19 pandemic, which contrasts with the conventional wisdom of flight to liquidity during crises. We identify the increased reliance on fixed-income mutual funds for liquidity provision as an important contributing factor to this phenomenon. Theoretically and empirically, we show that fixed-income mutual funds transform liquidity by issuing redeemable fund shares backed by a portfolio of liquid and illiquid assets while meeting redemption requests by first selling more liquid assets in their portfolios. Therefore, when investors redeem their fund shares en masse, funds' pecking order of liquidation generates pronounced selling pressure for liquid assets, effectively turning investors' flight to liquidity into the observed reverse flight to liquidity in financial markets. Such volatility in asset markets can be alleviated when financial intermediation is provided by commercial banks.
Keywords: Mutual fund, liquidity transformation, flight-to-liquidity, COVID-19
JEL Classification: G23, G21
Suggested Citation: Suggested Citation