Mutual Fund Holdings of Credit Default Swaps: Liquidity, Yield, and Risk

Abstract

This study analyzes the motivations for and consequences of funds' credit default swap (CDS) investments using mutual funds' quarterly holdings from pre- to postfinancial crisis. Funds invest in CDS when facing unpredictable liquidity needs. Funds sell more in reference entities when the CDS is liquid relative to the underlying bonds and buy more when the CDS-bond basis is more negative. To enhance yield, funds engage in negative basis trading and sell CDS with the highest spreads within rating categories, and with spreads higher than those of their bond portfolios. Funds with superior portfolio returns also demonstrate more skill in CDS trading.