Overview

The liquidity transformation of mutual funds and exchange-traded funds (ETFs) is examined as a potential source of corporate bond market fragility. Greater exposure to plausibly exogenous outflows from ETFs significantly increases a bond’s yield spread for seven months compared to same‑issuer bonds. The impact of active and index mutual fund outflows is insignificant, except for a one‑month effect from exposure to active funds with fewer liquid assets. The differential flow-driven pressure results are attributed to short-term positive feedback strategies by ETF investors and impaired arbitrage propagating secondary ETF market shocks. ETFs also exacerbate first-mover incentives among active mutual fund investors.