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

Abstract

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.