Mutual Fund Holdings of Credit Default Swaps: Liquidity Management and Risk Taking

Using a comprehensive dataset of mutual funds’ quarterly holdings of credit default swap (CDS) contracts during 2007-2011, we analyze the motives for and consequences of mutual funds’ participation in the CDS market preand post-financial crisis. Consistent with theoretical work, funds resort to CDS (especially selling) when they face unpredictable liquidity needs and when the CDS securities are liquid relative to the underlying bonds. Funds also take advantage of the negative basis between CDS and bond yields especially for the relatively illiquid bonds. Smaller funds follow leading funds in initiating CDS contracts on new reference entities. Moreover, the reference entities that attracted the highest selling interests from the largest mutual funds are disproportionately firms that were perceived to be “too large to fail” or “too systemic to fail.”