Carbon Emissions, Mutual Fund Trading, and the Liquidity of Corporate Bonds

This paper investigates the effect of climate risks on corporate bond mutual funds’ trading activities and explores its mechanism. We find that investor flows negatively respond to mutual funds’ carbon exposure, using the Paris Agreement as a shock event. Such carbon-induced redemptions prompt mutual funds to sell bonds issued by high-carbon companies, especially for funds with high outflow-to-carbon sensitivity. Our findings do not support the alternative hypothesis that a fundamental shift in funds’ investment preferences drives the reduction in high-carbon holdings. Finally, we document a deterioration in the liquidity of high-carbon bonds, particularly those heavily owned by mutual funds. This paper was accepted by Lukas Schmid, finance. Funding: J. Cao acknowledges grants from the Research Grant Council of the Hong Kong Special Administrative Region, China [Projects GRF 14501720, 14500621, and 15500023] and support from the PolyU Research Centre for Quantitative Finance [Project P0050344]. X. Zhan acknowledges grants from the National Natural Science Foundation of China [Grants 72271061 and 2022hwyq15]. W. Zhang acknowledges a grant by Ministerio de Ciencia, Innovación y Universidades /Agencia Estatal de Investigación /10.13039/501100011033 / Fonds Européen De développement Régional, Unión Europea [Grant PID2023-152707NA-I00]. The views expressed herein are those of the authors and do not necessarily reflect those of the Federal Reserve Board or its staff. L. Zhou acknowledges the financial support of the Fundamental Research Funds for the Central Universities. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2023.01867 .