Abstract
I show equity mutual funds invest less in companies with higher inside debt, whereas corporate bond funds invest more in such companies. The e ffect 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 e ffect of inside debt on portfolio allocation is stronger in fi rms with higher likelihood of default and higher idiosyncratic risk, fi rms su ffering 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.
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