CEO Inside Debt and Mutual Fund Investment Decisions

Abstract

I show equity mutual funds invest less in companies with higher inside debt, whereas corporate
bond funds invest more in such companies. The effect persists after accounting for endogeneity
using first-time mandatory disclosure of inside debt in 2007 as a natural experiment, and using
state-level personal income tax rates as an instrument for inside debt. The effect of inside debt on
portfolio allocation is stronger in firms with higher likelihood of default and higher idiosyncratic
risk, firms suffering from debt overhang, and firms with lower credit ratings. Lastly, equity funds
that underweight high-inside debt firms and bond funds that overweight them deliver positive
alphas.

Keywords: Inside Debt, Mutual Funds, CEO Compensation

JEL Classification: G23, G32, G33