Bond Funds and Credit Risk

We show that supply-side effects arising from the bond holdings of open-end mutual funds affect corporate credit risk. In our model, open-end funds are reluctant to roll over bonds with weak prospects, fearing future outflows. This lowers rollover prices, enhancing equityholders’ default incentives, and increases credit risk. Empirically, we find that in firms with weak prospects, fund holding shares increase CDS spreads, and more so when flows are more sensitive to performance. We provide direct evidence for the relevance of the rollover channel, use two quasi-experiments and an instrument to address endogeneity concerns, and rule out reverse causality via reaching-for-yield.