Mutual Fund Fragility, Dealer Liquidity Provision, and the Pricing of Municipal Bonds

Against the backdrop of COVID-19, we study how the interactions of mutual funds and dealers introduce fragility to the municipal bond market and induce lasting market impacts. During the crisis, trading surges, whereas dealers’ liquidity provision plunges for mutual-fund-held bonds, leading to greater price depressions in these bonds. Importantly, the crisis reshapes the market’s perceptions of mutual fund fragility risks, with the aftermath-yield spreads widening significantly more for bonds with greater mutual fund exposures. Such postcrisis pricing effects reflect dealers’ continued reluctance to provide liquidity for mutual fund–held bonds, and they are stronger for bonds whose mutual fund holders are more susceptible to investor runs. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2023.4912 .