COVID-19 posed the most severe stress test for financial markets and institutions since the Great Financial Crisis (GFC) of 2007-09. By some measures, the COVID shock’s peak impact was larger than that of the GFC—both the VIX rose higher and intermediaries’ estimated capital shortfalls were bigger. As a result, the COVID experience provides a natural laboratory for testing the resilience of many parts of the post-GFC financial system.

For example, the March 2020 dysfunction in the corporate bond market highlights the extraordinary fragility of a market that accounts for nearly 60% of the debt and borrowings of the nonfinancial corporate sector. Yield spreads over equivalent Treasuries widened further than at any time since the GFC, with bond prices plunging even for instruments that have little risk of default. (See Liang for an excellent overview.)

In this post, we focus on how, because of the contractual agreement with their shareholders, an extraordinary wave of redemptions created selling pressure on corporate bond mutual funds that almost surely exacerbated the liquidity crisis in the corporate bond market. To foreshadow our conclusions, we urge policymakers to find ways to reduce the gap between the illiquidity of the assets held by corporate bond (and some other) mutual funds and the redemption-on-demand that these funds provide. To reduce systemic fragility, we also urge them—as we did several years ago—to consider encouraging conversion of mutual funds holding illiquid assets into ETFs, which suffered relatively less in the COVID crisis….