article

1. Mutual Fund Liquidity Transformation
and Reverse Flight to Liquidity
Yiming Ma
Columbia GSB
Kairong Xiao
Columbia GSB
Yao Zeng
Wharton
2020 Financial Stability Conference
November 2020
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 1

2. Motivation
I Covid-19 crisis: traditionally liquid assets became strained
from unusually high selling pressures
I e.g. Haddad, Moreira, and Muir 20; Due 20; He, Nagel, and
Song 20; Kargar et al. 20
I Reverse ight to liquidity
I Conventional wisdom: ight to liquidity during market
distress
I high buying pressure for liquid assets
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 2

3. Heightened Selling Pressure in Treasury Market
-.4
-.3
-.2
-.1
0
.1
US
Treasury
CDS-adjusted
adjusted
swap
spreads
(%)
Jan Feb Mar Apr May
Treasury discount ↓
= Interest swap yield + Treasury CDS - Treasury yield ↑
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 3

4. Motivation
I The conventional negative correlation between Treasury yield
and VIX is reversed in Covid-19 crisis
Figure: Treasury Yields and VIX in Jan-Apr 2020
01-02
01-03
01-06
01-07
01-08
01-09
01-10
01-13
01-14
01-15
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1
1.5
2
2.5
30-year
Treasury
yield
(%)
20 40 60 80
VIX
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 4

5. Motivation
I Conventional wisdom: ight to liquidity
Figure: Treasury Yields and VIX in Aug-Sep 2008
08-01
08-04
08-05
08-06
08-07
08-08
08-11
08-12
08-13
08-14
08-15
08-18
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09-16 09-17
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09-22
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09-24
09-25
09-26
09-29
09-30
4
4.2
4.4
4.6
4.8
30-year
Treasury
yield
(%)
20 30 40 50
VIX
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 5

6. Heightened Selling Pressure in IG Corp Bonds
-4
-3
-2
-1
0
CDS-bond
basis
(%)
Jan Feb Mar Apr May
IG HY
CDS-bond basis ↓
= corporate bond CDS spread ↑ - corporate bond spread ↑↑↑
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 6

7. Motivation
The market for U.S. Treasuries has long been viewed as the
world's most liquid nancial market. That presumption was
questioned...
Still the World's Safe Haven? Darrel Due
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 7

8. What caused the reverse ight to liquidity phenomenon?
I Bond mutual funds
I Liquidity transformation → large redemption in crisis
I Pecking order of liquidation → concentrated sale of liquid
assets
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 8

9. What caused the reverse ight to liquidity phenomenon?
I Bond mutual funds
I Liquidity transformation → large redemption in crisis
I Pecking order of liquidation → concentrated sale of liquid
assets
I Implications of the reverse ight to liquidity phenomenon
I With more liquidity transformation by bond funds
I Liquid assets may experience more volatility
I May steer central banks towards providing liquidity backstops
to bond funds
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 8

10. Literature
1. Disruptions in liquid asset market during Covid-19
I Haddad, Moreira, and Muir 20 and Kargar et al. 20: document
debt market disruptions
I Due 20, He, Nagel, and Song 20: dealer constraints
I Falato, Goldstein and Hortacsu 20: fragility in fund ows
I A new explanation for heightened selling pressure in liquid assets
through mutual fund liquidity transformation
2. Financial intermediation by banks versus non-banks
I E.g. Diamond and Dybvig 83, Goldstein and Pozner 05, Hanson,
Shleifer, Stein, and Vishny 15, Ma, Xiao, and Zeng 20
I Asset-side implications of liquidity provision by mutual funds
versus banks
3. Mutual fund ows and nancial stability
I E.g. Chen, Goldstein, and Jiang 10, Goldstein, Jiang, and Ng 17,
Chernenko and Sunderam 17, Jiang, Li, and Wang 20
I ↑ fund asset illiquidity → ↑ potential for liquid asset market
disruptions
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 9

11. Roadmap
1. Aggregate Trends
2. Empirical Evidence
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 10

12. Bond Fund Growth
I Bond mutual funds have become increasingly important...
Total Assets
0
1000
2000
3000
4000
5000
Fund
assets
(billion)
1995 2000 2005 2010 2015 2020
Fund Shares/Deposits
.15
.2
.25
.3
.35
Fixed-income
fund
shares
/
Bank
deposits
1995 2000 2005 2010 2015 2020
I AUM: $1 trillion to $4.5 trillion from 2007 to 2019
I Shares/Deposits: 0.22 to 0.35 from 2007 to 2019
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 11

13. Mutual Fund Liquidity Transformation
Bank
Illiquid assets
Liquid assets
Demandable debt
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 12

14. Mutual Fund Liquidity Transformation
Bank
Illiquid assets
Liquid assets
Demandable debt
Bond funds
Illiquid assets
Liquid assets
Demandable equity
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 12

15. Mutual Fund Liquidity Transformation
Bank
Illiquid assets
Liquid assets
Demandable debt
Bond funds
Illiquid assets
Liquid assets
Demandable equity
I Like banks, bond funds provide liquidity by issuing liquid
claims backed by (mostly) illiquid assets
I Liquidity transformation may lead to rst-mover advantage,
e.g. Market value drops from 100 to 80 but NAV is still at 90
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 12

16. Pronounced Outows at Bond Funds
I Bond funds suered an unprecedented $264 billion outows in
March, 2020
Bond funds
-300
-200
-100
0
100
Fund
flows
(billion)
2000 2005 2010 2015 2020
Equity funds
-300
-200
-100
0
100
Fund
flows
(billion) 2000 2005 2010 2015 2020
I Equity funds suered much smaller outows → liquidity
transformation must matter...
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 13

17. Higher Asset Illiquidity, Larger Outows
I ...also evident from more pronounced outows at more illiquid
bond funds
-20
-10
0
10
Cummulative
fund
flows
(%
AUM)
Jan2020 Feb2020 Mar2020 Apr2020 May2020
Government Investment grade
High yield Loan
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 14

18. Concentrated Sales of Liquid Assets
I Liquid assets were disproportionately liquidated
-10
-5
0
Position
change
(%)
CCC-
CCC-
CCC
CCC+
B-
B
B+
BB-
BB
BB+
BBB-
BBB
BBB+
A-
A
A+
AA-
AA
AA+
AAA
Treasury
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 15

19. Large Aggregate Liquidations
I Aggregate Treasury liquidations by open-end funds amounted
to $236 billion in 2020Q1
-300 -100 100 300
Change in Treasuries (billion)
Money market funds
ETFs
Insurance companies
Nonfinancial business
GSEs
Banks
Closed-end funds
ABS
Credit unions
Pension funds
Foreign banking offices in U.S.
Broker dealers
Households
Mutual funds
Rest of the world
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 16

20. Empirical Evidence

21. Liquidity Transformation and Outows: Fund-level Evidence
Figure: Fund Outows versus Fund Liquidity Provision Index (LPI)
0
2
4
6
Fund
outflows
0 2 4 6 8
Liquidity Provision Index (LPI)
I LPI = per dollar expected contract payment - direct
liquidation value assets (Ma, Xiao and Zeng 19)
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 17

22. Cross-section Determinants of Outows
I High asset illiquidity → more outows
(1) (2) (3) (4)
Outow Outow Outow Outow
Fund illiquidity 0.546∗∗∗ 0.545∗∗∗ 0.537∗∗∗ 0.564∗∗∗
[0.092] [0.092] [0.094] [0.096]
Institutional 0.137 0.135 0.283
[0.203] [0.203] [0.204]
Index fund -0.259 -0.614
[0.595] [0.602]
Fund objective F.E. No No No Yes
Observations 6,355 6,355 6,355 6,355
Adj. R-squared 0.005 0.005 0.005 0.021
I Other controls: yield, return volatility, expense ratio, turnover
ratio
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 18

23. What did funds sell when they face redemption?

24. Reverse Flight to Liquidity: Pecking Order
Liquidationsi,j = βFund Outowj + γXi + θXj + i,j
Figure: Liquidation to Redemption Sensitivity by Bond Rating
-.5
0
.5
1
1.5
2
CCC-
CCC-
CCC
CCC+
B-
B
B+
BB-
BB
BB+
BBB-
BBB
BBB+
A-
A
A+
AA-
AA
AA+
AAA
Treasury
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 19

25. Pecking Order based on Relative Liquidity: Measure
Ranki,j =
X
i0
Sharei0,j × 1[Liquidityi Liquidityi0 ]
I Ranki,j is dened as the sum of shares of assets held by fund j
that are less liquid than bond i
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 20

26. Pecking Order based on Relative Liquidity: An Example
I Compare two identical Treasury bonds held by (1) a Treasury
fund and (2) a corporate bond fund
I Treasury bond fund has more liquid assets → ranked lower in
the pecking order
I Corporate bond fund has more illiquid assets → ranked higher
in the pecking order
I Corporate bond fund is more likely to sell the Treasury bond
for the same redemption
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 21

27. Reverse Flight to Liquidity: Pecking Order
Liquidationi,j = βOutowsj × Ranki,j + γXi,j + i,j
(1) (2) (3)
Open-end
All
Open-end
Active
Open-end
Passive
Outows 0.268∗∗∗
0.208∗∗∗
0.224∗∗∗
[0.016] [0.024] [0.035]
Outows*Rank 0.198∗∗∗
0.386∗∗∗
0.082
[0.047] [0.060] [0.151]
Bond F.E. Yes Yes Yes
Fund objective F.E. Yes Yes Yes
Observations 79,050 37,945 39,410
Adj. R-squared 0.067 0.071 0.050
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 22

28. Did funds' selling pressure aect prices of liquid
assets?

29. Bond yields by liquidation rank
Figure: Pecking order of liquidation and bond yield
-40
-20
0
20
40
Yield
(bps)
Feb Mar Apr May
Q1 Q2
Q3 Q4
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 23

30. Impact on Asset Prices
Imputed Outowi,t =
X
j
Fund outowj,t ×
Holdingi,j,2019Q4
P
k Holdingi,k,2019Q4
Returni,t = βImputed Outowi,t × High ranki + γXi,t + i,t
(1) (2) (3)
Return Return Return
Outows -1.646 -1.741 -1.856
[1.167] [1.174] [1.194]
Outows*High rank -3.443∗∗ -3.550∗∗ -3.506∗∗
[1.426] [1.433] [1.459]
Rating-Time F.E. Yes No No
Maturity-Time F.E. Yes No No
Issuer F.E. No Yes Yes
Bond F.E. No No Yes
Observations 398,678 398,678 398,677
Adj. R-squared 0.174 0.175 0.166
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 24

31. What were the eects of Fed interventions ?

32. Fed Intervention
Unprecedented intervention by the Fed in xed income markets:
I March 15: Announced purchase of Treasuries
I March 23: Announced purchase of IG corporate bonds
I April 9: Announced extension of corporate bond purchase
I Larger volume
I Include fallen angels
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 25

33. Eect of Fed Interventions on Fund Flows
Outflowsi,t = βFedInterventiont + γXi,t + i,t
(1) (2) (3) (4)
Govt IG HY BL
Treasury bond purchase 0.014 0.043 0.093∗∗∗
0.093∗∗∗
[0.032] [0.039] [0.026] [0.033]
Corp bond purchase 0.217∗∗∗
0.366∗∗∗
-0.057 0.161∗∗∗
[0.040] [0.063] [0.035] [0.051]
Corp bond purchase expansion 0.057∗∗∗
-0.039∗∗
-0.069∗∗∗
-0.073∗∗∗
[0.017] [0.019] [0.008] [0.010]
Control Yes Yes Yes Yes
Fund xed eects Yes Yes Yes Yes
Month xed eects Yes Yes Yes Yes
Observations 13,573 6,452 17,819 9,364
Adj. R-squared 0.058 0.071 0.067 0.096
I Announcements of corp bond purchase stopped outows, but Treasury
bond purchase did not
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 26

34. Eect of Fed Interventions on Fund NAV
∆NAVi,t = βFedInterventiont + γXi,t + i,t
(1) (2) (3) (4)
Govt IG HY BL
Treasury bond purchase 0.241∗∗
0.188 -2.336∗∗∗
-2.618∗∗∗
[0.119] [0.236] [0.274] [0.290]
Corp bond purchase 0.901∗∗∗
0.866∗∗
-1.261∗∗
-1.941∗∗∗
[0.178] [0.400] [0.486] [0.487]
Corp bond purchase expansion 0.399∗∗∗
1.616∗∗∗
1.621∗∗∗
1.114∗∗∗
[0.039] [0.066] [0.111] [0.095]
Control Yes Yes Yes Yes
Fund xed eects Yes Yes Yes Yes
Month xed eects Yes Yes Yes Yes
Observations 13,565 6,451 17,816 9,357
Adj. R-squared 0.180 0.427 0.323 0.377
I Announcements of corp bond purchase increased NAVs, but Treasury
bond purchase did not
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 27

35. Why did reverse ight to liquidity emerge this time?
I Increased liquidity transformation by funds since last crisis
I Bond fund AUM: $1 trillion to $4.5 trillion from 2007 to 2019
I With increased mutual fund liquidity transformation, going
forward:
I Increased volatility in traditionally liquid assets
I Are US Treasury Bonds Still a Safe Haven? (He and
Krishnamurthy, 2020)
I Mutual funds conduct liquidity transformation outside public
liquidity backstops
I More reliance on unconventional central bank asset purchases
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 28

36. Conclusion
1. What caused the reverse ight to liquidity phenomenon?
Mutual funds transform liquidity by issuing demandable equity
shares + using pecking order of liquidations
2. What are the policy eects?
The purchase of illiquid assets directly alleviates fund outows
and is more eective than the purchase of liquid assets
3. What was special about the Covid-19 crisis? Could everything
happen again in the future?
Migration of liquidity transformation to mutual funds
Yiming Ma Kairong Xiao Yao Zeng Mutual Funds and Reverse Flight to Liquidity 29