DP14134 Bond Funds and Credit Risk

Author(s): Jaewon Choi, Amil Dasgupta, Ji Yeol Jimmy Oh
Publication Date: November 2019
Keyword(s): bond rollover, career concerns, default-liquidity loop, flow fragility, Fund flows
JEL(s): G23, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14134

We show that supply side effects arising from the bond holdings of open-end mutual funds affect corporate credit risk through a refinancing channel. In our framework, bond funds exposed to flow-performance relationships become excessively reluctant to refinance bonds of companies with poor cash flow prospects. This lowers refinancing prices, enhancing incentives for strategic default, thus engendering a positive association between bond funds' presence and credit risk. Empirically, we find that firms with a large share of mutual fund holdings experience increases in CDS spreads, particularly for funds that are more sensitive to flows. We address potential endogeneity issues by using fund acquisitions as exogenous shocks to funds' flow concerns.