Counterparty Risk in Bond Mutual Funds: Evidence from Credit Default Swaps Positions

Abstract

We examine the credit default swaps (CDS) positions of bond mutual funds over 2004-2009. We find that CDS are more commonly used by funds with the greatest transaction-cost benefit and that CDS usage is associated with lower flow-motivated trading in the bond market. We also find that bond funds’ net-buying of CDS protection dropped significantly during the 2007-2009 financial crisis. Consistent with bond funds’ avoiding buy protection positions out of heightened concerns about the counterparty risk of swap dealers, we find that funds are more likely to close existing buy-protection CDS that have greater counterparty credit risk, as measured by positions in which the counterparty has a high default probability or a high default correlation with the reference entity. Furthermore, as a further contributor to a decrease in net-buy protection during the crisis, we find an increase in funds’ selling of CDS protection during the crisis, especially to banks in greater financial distress. Finally, we show that the portfolios of CDS-users displayed significantly higher systematic credit risk and lower returns during the crisis.