Why More Cash Does Not Automatically Make Bond Funds Safer in a Run
Bank-loan and high-yield mutual funds are the subject of this series, and the question is deceptively simple: if a fund holds more cash, why would it not be safer when investors rush to redeem? The answer requires separating a fund’s immediately available resources from the liquidity of everything else it owns. Readers who make that distinction can judge what a cash buffer actually protects, what it leaves exposed, and why the same ratio may mean something different in a tariff shock than in a pandemic.
These are open-end mutual funds. Investors can generally ask for their money back each day, but the funds do not necessarily own assets that can be sold each day without a meaningful price concession. Bank-loan funds concentrate on bank loans; high-yield funds concentrate on non-investment-grade corporate bonds. Both are relatively illiquid asset classes compared with cash or Treasury bills. That combination creates the central tension: the fund promises frequent access to the investor’s money while its portfolio may require time, a willing buyer, and a functioning market to turn into money.
A “run” in this setting does not require a bank-style promise to return every dollar on demand. It can begin with a wave of redemption requests that is large relative to the fund’s liquid resources or large relative to what the market can absorb. The fund has to choose how to meet those requests. It may use cash and near-cash assets, sell securities, allow its portfolio to shrink, or combine those actions. If it sells less-liquid corporate debt into a weak market, the sale itself can push prices down. That affects the value of the portfolio still held by the fund and can make the cost of remaining redemptions higher.
The practical issue is therefore not simply whether a fund has cash. It is whether the cash is enough for the withdrawals that may arrive, whether it buys enough time to avoid damaging sales, and what the remaining portfolio looks like after that time is used.
The Promise That Creates the Risk
Liquidity transformation is the name for the mismatch between the timing of withdrawals and the timing of asset sales. An open-end fund offers daily redemptions even when some holdings may take longer than a day to sell without significantly changing their market value. That mismatch is useful in normal conditions: investors receive convenient access while the fund invests in assets that may offer a different risk and return profile than cash. But convenience for the investor does not remove the market constraint on the asset.
The constraint becomes visible when many investors act together. Suppose a fund receives redemptions that exceed the cash it wants to spend immediately. It must raise more money. Selling a liquid Treasury bill is not the same problem as selling a concentrated position in a thinly traded corporate instrument. The first may have little effect on the market price. The second may require accepting a lower price, waiting for a buyer, or selling several positions whose prices are connected. The fund’s net asset value then reflects a market under pressure, and the remaining shareholders bear part of the consequence through dilution or lower portfolio value.
That sequence does not mean every redemption wave becomes a fire sale. Funds can hold buffers, stagger sales, receive new subscriptions, or operate in markets that remain deep enough to absorb transactions. It does mean that the safety of a redemption promise depends on conditions outside the cash line itself. Market depth, the concentration of holdings, the difference between quoted and realizable prices, and the behavior of other investors all matter.
The Federal Reserve’s 2026 update places this question in the specific context of bank-loan and high-yield mutual funds. The sectors are not the same size or on the same trajectory. Between the fourth quarter of 2019 and the fourth quarter of 2025, bank-loan mutual-fund net assets declined by $19 billion, or 21 percent, to $71 billion. High-yield mutual-fund assets rose 13 percent to $263 billion. Those figures do not establish that one sector is safer. They establish why sector context matters: a cash percentage sits inside a portfolio and a market structure, not in isolation.
Both sectors also hold relatively small fractions of liquid assets such as cash and Treasury bills while investing primarily in assets that are less immediately saleable. A buffer can be meaningful without being large enough to cover every plausible outflow. Conversely, a large buffer may coexist with a portfolio whose difficult-to-sell positions have become more important. The question is always what the buffer is being measured against.
The loop in the diagram is possible, not inevitable. Its purpose is to show why the first question—how much cash is available?—is only the first branch in the analysis. A fund can use cash to avoid an immediate sale, but that does not make its other holdings liquid. It can also sell assets without triggering a wider reaction if the market is functioning normally. The vulnerability appears when the fund’s promised withdrawal horizon and the market’s sale horizon diverge at the same time that many investors are trying to exit.
Why Cash Is Only One Side of the Balance
A cash buffer has a real economic function. It can meet some redemptions without forcing the fund to sell the least liquid positions immediately. It can give a manager time to choose which assets to sell, wait for better market depth, or let incoming purchases offset some withdrawals. In that sense, liquid assets can reduce the amount of urgent selling required.
But a buffer is not the same as a prediction of investor behavior. A fund may hold more liquid assets because its managers recognize that the portfolio is difficult to sell or because they expect larger withdrawals. In that case, a high liquidity ratio can be a response to risk. It may be evidence of preparation, but it may also identify funds whose underlying exposures or investor base make preparation necessary. The ratio alone cannot tell us which explanation dominates.
Nor does cash reveal the full condition of the portfolio. A fund can have few assets in the hardest-to-value category and still own substantial positions whose market depth is limited. It can hold assets that are technically tradable but difficult to sell in size without moving the price. It can also face a common shock in which many funds seek the same buyers at once. The distinction is between having an asset that can be converted to cash in some circumstances and having enough capacity to convert it quickly at a price that preserves value.
The Federal Reserve’s evidence illustrates this distinction without offering a universal safety score. For bank-loan funds, the median liquidity ratio reached almost 10 percent of net assets in 2021 and then settled at about 4.5 percent from 2024 onward. At the same time, the median share of Level 3 assets—assets valued with significant unobservable inputs—rose again from its post-pandemic lows and approached the levels seen during the pandemic-era spike. The authors interpret stable liquid ratios alongside rising illiquidity as an increase in liquidity-transformation risk on balance.
High-yield funds provide a useful contrast. Their median liquidity ratio remained about 4 percent from 2020 onward, while their median illiquidity ratio stayed relatively flat and the spread across funds narrowed. The Federal Reserve says transformation activity appears to have declined on balance for this sector. That is a different aggregate pattern, not a guarantee that every high-yield fund is resilient or that a four-percent ratio has a fixed meaning in every market.
The comparison makes the core point sharper. If two funds each report a similar amount of cash, the number does not answer whether their remaining assets can be sold, whether their investors are likely to redeem, or whether the market can absorb the sales. If a fund’s cash ratio is stable while its difficult-to-value exposure rises, the buffer has not necessarily become worthless; the obligation it must cover has become more demanding relative to the buffer. If both ratios are stable, the fund may be in a better position, but the evidence still does not reveal concentration, market depth, or the next shock.
What the Evidence Can—and Cannot—Show
This series therefore treats a liquidity ratio as a starting condition, not a verdict. The Federal Reserve uses a ratio that adds cash and cash equivalents, Treasury bills, and short-term investment vehicles, then divides that amount by total net assets. Its companion illiquidity ratio measures the share of net assets in Level 3 assets. These measures are useful because they provide a consistent way to examine trends across funds and time. They are limited because classification practices differ, Level 2 and Level 3 categories can shift, and market depth is not observed directly.
That limitation changes how the stress evidence should be read. In the April 2025 tariff-induced volatility, funds with above-median ex-ante liquidity experienced larger average weekly outflows than funds below the median in both the bank-loan and high-yield groups. In March 2020, the pattern was different: bank-loan funds with above-median ex-ante liquidity experienced smaller average monthly outflows, while the high-yield difference was not statistically significant. These observations do not show that cash caused withdrawals in one episode or prevented them in the other. They show that the relationship between a buffer and redemption behavior is conditional.
A plausible explanation is that precautionary liquidity management helps in ordinary volatility but does not control a broad market shock. Another is that funds holding more liquidity differ in ways the ratio does not capture: they may own riskier assets, serve investors with different withdrawal patterns, or have built their buffers in anticipation of stress. The supplied evidence supports considering those explanations; it does not identify their separate causal contributions.
The same discipline applies to regulation. Later analysis will examine how liquidity-management rules, governance, and reporting are designed to address the mismatch. Those systems matter because a fund’s resilience is not just a private choice to hold cash. It also depends on how assets are classified, how shortfalls are escalated, and what information reaches the fund, its board, regulators, and the public. But regulatory compliance should not be confused with a promise that no investor run can produce price impact.
The useful question is narrower and harder than “Is this fund liquid?” Ask instead: liquid for which redemptions, over what horizon, under what market conditions, and at what price? Cash answers only part of that question. The rest requires looking at the portfolio that cash does not cover, the investors who may seek it, the stress regime that brings them together, and the evidence available to judge the interaction. That is why more cash can make a bond fund better prepared without automatically making it safe in a run—and why the judgment must remain conditional rather than numerical.