Fund Flows, Liquidity, and Asset Prices

Abstract

This paper shows empirically that corporate bond mutual funds, facing fund flow risk and liquidity risk, distort expected corporate bond returns due to their hedging demands against the risks as financial intermediaries. Funds underweight corporate bonds that are highly exposed to such risks, ultimately incurring substantial risk premia for fund flow betas: the co-movements of a bond's returns and, notably, liquidity costs with aggregate fund flow shocks. Using both standard asset pricing tests and identification strategies that exploit distinctive structures in the corporate bond markets, this paper shows that the aggregate fund flow shocks are priced, while ruling out various alternative a..