Bond Funds and Credit Risk
73 Pages Posted: 25 Nov 2019 Last revised: 15 Sep 2020
Date Written: September 1, 2020
We show that supply side effects arising from the bond holdings of open-end mutual funds affect corporate credit risk. In our model, funds exposed to flow-performance relationships are reluctant to refinance bonds of companies with poor cash flow prospects fearing future investor outflows as a result of potential default events. This lowers refinancing prices, enhancing incentives for strategic default by equityholders, engendering a positive association between bond funds’ presence and credit risk. Empirically, we find that in firms with poor cash flow prospects, active fund bond holdings are associated with increased CDS spreads, more so when funds are more sensitive to flows. We use an instrumental variable approach and a quasi-experiment based on the departure of Bill Gross from PIMCO to address the endogeneity between fund holdings and credit spreads.
Keywords: fund flows, flow fragility, career concerns, bond rollover, default-liquidity loop
JEL Classification: G23, G32
Suggested Citation: Suggested Citation