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

Using mutual funds' quarterly holdings of credit default swap (CDS) contracts over 2007-2011, we analyze the motives for and consequences of funds' CDS investment pre- and post-financial crisis. Consistent with theories, funds resort to CDS selling when facing unpredictable liquidity needs and when the CDS security is liquid relative to the underlying bond, and to CDS buying as part of a "negative basis trade" when the bond is illiquid. Smaller funds follow leading funds in yield searching. The reference entities that attracted the highest selling interest from the largest funds were disproportionately firms perceived to be "too large/systemic to fail."