The Use of Credit Default Swaps by Bond Mutual Funds: Liquidity Provision and Counterparty Risk
48 Pages Posted: 12 Sep 2017 Last revised: 30 Dec 2017
Date Written: December 28, 2017
Corporate bond mutual funds increased their selling of credit protection in the credit default swaps (CDS) market during the 2007-08 financial crisis. This trading activity was primarily in multi-name CDSs, greater among larger and established funds, and directed towards counterparty dealers in financial distress. Funds that sold credit protection during the crisis experienced greater credit market risk and superior post-crisis performance, consistent with higher expected returns from liquidity provision. Funds using Lehman Brothers as a counterparty experienced abnormal outflows and returns of -2% immediately following Lehman’s bankruptcy, suggesting that funds’ opportunistic trading in CDSs exposed investors to counterparty risk.
Keywords: bond funds, credit default swaps, crisis, liquidity provision, counterparty risk
JEL Classification: G11, G12
Suggested Citation: Suggested Citation