Treasury Liquidity, Funding Liquidity and Mutual Fund Performance

Abstract

This paper links the illiquidity of US Treasuries to funding liquidity and shows that dealers’ financial constraints tighten after a positive shock to Treasury illiquidity. Consistent with the empirical properties of funding liquidity, illiquidity of Treasuries predicts changes in the TED spread and VIX index. Further, bond illiquidity is the only variable which consistently predicts the equity premium across sub-periods when controlling for all other common predictors. Moreover it is the only variable which survives the Goyal and Welch (2008, Review of Financial Studies) out-of-sample tests. Using it as a priced risk factor helps to explain cross-sectional returns of mutual funds. Controlling for stock market liquidity risk, funds with higher funding liquidity risk outperform funds with lower funding liquidity risk by 4.9% per annum. Fund inflows associated with lower funds’ liquidity constraints and higher funding liquidity risk predict superior performance.