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

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1 Mutual Fund Holdings of Credit Default Swaps: Liquidity Management and Risk Taking Wei Jiang, Columbia Business School and Zhongyan Zhu, Chinese University of Hong Kong For 2 nd Annual Conference on the Regulation of Financial Markets By CFP Smith School of Business and SEC SEC Headquarters, Washington DC, May 1,

2 Simple facts: mutual fund holdings of single name CDS positions, Overall, heavier CDS sell positions than buy ones Period #Positions Amount ($1,000s) Sell Amount ($1,000s) #Funds 2007Q ,154,975 8,535, Q ,898,276 9,315, Q ,034,953 13,654, Q ,064,073 14,306, Q ,317,488 15,024, Q ,161,554 17,443, Q ,989,193 15,986, Q ,565,593 11,880, Q ,158,307 9,560, Q ,392,066 8,080, Q ,694,105 8,446, Q ,976,014 9,145, ,406, ,379,

3 Research question Why did mutual funds hold more short CDS positions? Oehmke and Zawadowski (2014a): Liquidity transformation of CDS Rajan (2006): Benchmark performance evaluation and risk taking 3

4 Data sample Mutual fund CDS holdings, manually collected Source: SEC N-Q, N-CSR, and N-CSRS quarterly filings Filter on mutual funds: regular CDS usage 284 mutual funds, 60 trust series, 33 mutual fund families CDS on single name reference entities 445 reference entities 66,495 CDS positions $241.4 billion quarter end holdings, of which $141 billion sell positions Merged with CRSP mutual funds database 4

5 Stylized facts Large vs. small mutual funds PIMCO took dominant role Large mutual fund families, PIMCO ($4.1 billion) and next 9 ($2.1 billion), took on more sell positons than small, the rest 23 ($1.4 billion), mutual fund families Mutual fund families #Positions Amount ($1,000s) % of total Sell Amount ($1,000s) Buy Amount ($1,000s) All ,406, % 141,379, ,026,929 PIMCO ,074,496 62% 95,106,951 53,967,545 Next ,445,008 24% 33,149,319 24,295,689 Rest ,887,093 14% 13,123,398 21,763,695 5

6 Stylized facts, cont d Large vs. small CDS reference entities Top 50 CDSs (defined by dollar amount) were heavily traded Sell positions of top 50 CDSs were higher than buys Rest 399 CDSs, buys were more than sells Top 50 CDSs had higher CDS spreads than the rest 399 CDSs CDS reference entity Amount ($1,000s) % of total Sell Amount ($1,000s) Buy amount ($1,000s) Avg spread in 2007 Avg spread in 2008 Each position is classified as sell (59%), offsetting buy (2%), hedging buy (21%), or speculative buy (17%) Avg spread in 2009 Top ,945,903 64% 114,762,631 40,183, Next 50 32,928,095 14% 7,885,987 25,042, Rest ,532,599 22% 18,731,050 34,801,

7 Tests on liquidity management, fund level, 1/2 Propensity of CDS usage One standard deviation increase of flow volatility implies 2.5 percentage points increase in sell probability (unconditional sell probability 4.6%) Multinomial logit, baseline outcome no-buy-no-sell Controls: Fund size, age, rank, Lipper dummy, and quarter dummy. S.e. clustering at fund level Logit Dependent variable: Any sell Any buy Buy no sell Logit, vs. no buy no sell Both buy and sell Sell no buy (1) (2) (3) (4) (5) Flow volatility 12.51*** 8.919*** *** 13.57*** (2.442) (2.494) (3.757) (2.786) (3.984) Portfolio Turnover 0.294*** 0.279*** 0.123*** 0.316*** 0.168*** (0.0552) (0.0538) (0.0456) (0.0615) (0.0611) # observations 19,137 19,454 16,000 18,565 15,291 % (Dep var =1) 5.22% 4.87% 1.64% 3.68% 2.06% Pseudo R squared

8 Tests on liquidity management, fund level, 2/2 Intensity of CDS usage One standard deviation increase of flow volatility implies 1.61 percentage points increase in sell intensity (unconditional selling intensity 0.13%) Controls: Fund size, age, rank, Lipper dummy, and quarter dummy. S.e. clustering at fund level Tobit Gross sell intensity Gross buy intensity Dependent variable: (1) (2) Flow volatility 38.65*** 26.83*** (9.285) (8.831) Portfolio Turnover 0.913*** 1.093*** (0.171) (0.207) # observations 19,454 19,454 Pseudo R squared

9 Tests on liquidity management, fund-cds level, 1/2 Propensity of CDS usage Controls: fund size, age, performance rank; Lipper fund category dummy; quarter dummy; heteroskedasticity standard errors clustering at fund level Logit Any sell Any buy Any sell Any buy Dependent variable (1) (2) (3) (4) Flow volatility 14.00*** 7.520** (3.389) (3.091) Portfolio turnover 0.233*** 0.328*** (0.0559) (0.0530) Bond turnover (0.221) (0.252) (0.224) (0.256) # CDS contracts 0.724*** *** 0.732*** *** (0.0556) (0.0178) (0.0555) (0.0182) Assets reference entity 0.589*** 0.137*** 0.596*** 0.141*** (0.0417) (0.0266) (0.0431) (0.0275) # observations 4,094,042 4,117,080 4,094,042 4,117,080 % (Dep var =1) 0.075% 0.140% 0.075% 0.140% Pseudo R squared

10 Tests on liquidity management, fund-cds level, 1/2 Propensity of CDS usage Controls: fund size, age, performance rank; Lipper fund category dummy; quarter dummy; heteroskedasticity standard errors clustering at fund level Multinomial logit Buy no sell Both buy and sell Sell no buy Dependent variable: (5) (6) (7) Flow volatility 7.645** *** (3.156) (4.429) (3.455) Portfolio turnover 0.329*** 0.328*** 0.222*** (0.0541) (0.0657) (0.0594) Bond turnover *** (0.275) (0.510) (0.231) # CDS contracts *** 0.568*** 0.770*** (0.0163) (0.140) (0.0644) Assets reference entity *** 0.706*** 0.581*** (0.0318) (0.0881) (0.0422) # observations 4,073,070 2,756,756 4,047,326 % (Dep var =1) 0.131% 0.015% 0.065% Pseudo R squared

11 Tests on liquidity management, fund-cds level, 2/2 Intensity of CDS usage Controls: fund size, age, performance rank; Lipper fund category dummy; quarter dummy; hetero. standard errors clustering at fund level Tobit Dependent variable Gross sell intensity Gross buy intensity Gross sell intensity Gross buy intensity (1) (2) (3) (4) Flow volatility 57.98*** 22.24** (16.00) (9.404) Portfolio turnover 1.016*** 1.066*** (0.250) (0.202) Bond turnover * (0.962) (0.729) (0.957) (0.732) # CDS contracts 2.895*** 0.229*** 2.899*** 0.238*** (0.342) (0.0668) (0.348) (0.0735) Assets reference entity 2.596*** 0.434*** 2.603*** 0.448*** (0.281) (0.102) (0.284) (0.0996) # observations 4,147,385 4,147,385 4,147,385 4,147,385 Pseudo R squared

12 Evidence on the rational of risk taking by PIMCO PIMCO Investment Outlook, May 2006, William H. Gross it is important to recognize that General Motors is a canary in this country s economic coal mine. TIME, Sep 16, 2008: Even Bond Guru Bill Gross Can't Escape With so many bad assets floating around finance firms, his strategy had been to only invest in "high-quality institutions under the umbrella of regulatory protection On his original list Gross had five deposit-taking banks (Bank of America, JP Morgan, Wells Fargo, Citigroup and Wachovia) and five investment banks (Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs) Interpretation: PIMCO interested in too-big-to-fail firms. 12

13 Identification: leader-follower PIMCO: the leader In t-1 quarter, PIMCO disclosed positions. Our focus is on large net positions Non-PIMCO mutual funds: the followers The dependent New Selling i,j,t (dummy) is equal to one if fund i discloses CDS net selling in the reference entity j in period t and the fund did not disclose any net selling position j in period t-1. The unit of observation: the fund-reference entity-quarter Unconditional/conditional: quarter t consists of all 445/the number of entities for which fund i did not already have a net short position on in quarter t-1 Speculative buy is defined in a similar way Test: Whether/How non-pimco mutual funds benchmark PIMCO? on net selling positions: risk taking on speculative buy positions: relative performance evaluation 13

14 Tests on net selling (risk taking), 9 mutual fund families, unconditional Logit: Propensity to open net selling position. Control: quarter dummy Dependent: Non-PIMCO Net selling (2) (4) (6) PIMCO Lead (t-1) 0.619*** 0.934*** 1.698*** (0.0996) (0.0951) (0.216) Assets Reference Entity (log) 0.352*** 0.272*** 0.445*** (0.0261) (0.0221) (0.0523) Spread-5year (t-1) 38.14*** 6.415*** 0.628* (1.471) (0.333) (0.339) Fund TNA (log) *** 0.425*** (0.0321) (0.0281) (0.0830) # observations 65,150 87,999 64,451 % (Dep var =1) 0.953% 0.819% 0.163% Pseudo R squared Similar results for conditional test 14

15 Tests on net selling (risk taking), 23 mutual fund families, unconditional Logit: Propensity to open net selling position. Control: quarter dummy Dependent: Non-PIMCO Net selling (2) (4) (6) PIMCO Lead (t-1) 1.356*** 1.109*** 2.273*** (0.136) (0.123) (0.217) Assets Reference Entity (log) 0.410*** 0.433*** 0.441*** (0.0350) (0.0293) (0.0520) Spread-5year (t-1) 24.67*** 2.979*** (2.468) (0.605) (0.305) Fund TNA (log) 0.168*** 0.133*** 0.338*** Control Similar results for conditional test (0.0478) yes (0.0390) yes (0.0688) yes # observations 98, ,143 93,472 % (Dep var =1) 0.281% 0.268% 0.119% Pseudo R squared

16 Tests on speculative buy (benchmarking leader), 9 mutual fund families Logit: Propensity to open positions on speculative buy. Control: quarter dummy Dependent: Non-PIMCO Speculative buy (2) (4) (6) PIMCO Lead (t-1) 0.529*** 0.558*** 0.728** (0.150) (0.162) (0.289) Assets Reference Entity (log) *** ** (0.0349) (0.0326) (0.0630) Spread-5year (t-1) *** ** (5.462) (1.449) (1.139) Fund TNA (log) 0.146*** 0.118*** 0.272*** Control (0.0369) yes (0.0397) yes (0.0829) yes # observations 71,708 99,877 70,995 % (Dep var =1) 0.708% 0.370% 0.139% Pseudo R squared

17 Tests on speculative buy (benchmarking leader) 23 mutual fund families Logit: Propensity to open positions on speculative buy. Control: quarter dummy Dependent: Non-PIMCO Speculative buy (2) (4) (6) PIMCO Lead (t-1) 1.193*** 0.434*** 0.853*** (0.121) (0.142) (0.178) Assets Reference Entity (log) * (0.0290) (0.0311) (0.0438) Spread-5year (t-1) *** *** *** (4.998) (2.237) (1.142) Fund TNA (log) *** (0.0336) (0.0318) (0.0481) Control yes yes yes # observations 98, , ,437 % (Dep var =1) 0.530% 0.339% 0.238% Pseudo R squared

18 Conclusion Understood the motivation of CDS usage by mutual funds: liquidity management Identified the leader and the followers Understood why the leader took sell positions on selective CDSs Provided explanations on follower s positions: benchmarking leader Sell positions, risk taking Buy positions, relative performance evaluation Large vs. small mutual funds. 18

Mutual Fund Holdings of Credit Default Swaps: Liquidity Management and Risk Taking 1

Mutual Fund Holdings of Credit Default Swaps: Liquidity Management and Risk Taking 1 Wei Jiang 2 Columbia Business School Zhongyan Zhu 3 CUHK Business School, The Chinese University of Hong Kong First