Abstract This paper investigates how capital supply from mutual funds affects municipal bond financing, making three key contributions. First, we introduce an identification strategy using the rule-based update of Morningstar ratings for 5-year-old funds, isolating supply-side effects from fund and issuer fundamentals. The results indicate that exogenous fund flows increase bond issuance probability and decrease yields. Second, these fund flows lead to more issuances when funds and issuers are connected through underwriters, highlighting relationship lending in municipal bond financing. Third, municipal issuers leverage favorable financing conditions for new issuance of revenue bonds, which translates into higher local house prices.

We find evidence of widespread stale pricing in bond mutual funds and the resulting risks of dilution and fragility. A principal driver of this phenomenon is the high illiquidity of funds’ holdings, which makes accurate pricing difficult and provides funds with greater discretion over valuation. Consequently, net asset values (NAVs) are extremely stale and fund returns are predictable over several days and weeks, particularly during market crises. Opportunistic traders withdraw capital from overvalued funds, exacerbating the risk of fund runs, while buy-and-hold investors face annual dilution of around $1.2 billion. Our results highlight adverse consequences of insufficient fair valuation practices that remain pervasive even after corrective regulations that followed the 2003 market-timing scandal.