CEO Inside Debt and Mutual Fund Investment Decisions

Consistent with the incentive implication of inside debt, I show that active equity mutual funds invest less in companies whose CEOs are awarded with higher debt-like compensation, whereas corporate bond mutual funds invest more in such companies. This finding persists after accounting for endogeneity: first, I use the first-time disclosure of inside debt following the 2007 SEC disclosure reform as a natural experiment; and second, I use state personal income tax rates as an instrument for CEOs' willingness to receive inside debt. Moreover, during the recent financial crisis, both equity and bond funds were more attracted to high-inside debt firms. Furthermore, the effect of inside debt on portfolio allocation increases as the interest of equity holders and debt holders diverge, by being close to default, having higher risk, suffering from debt overhang, and having low credit ratings. Lastly, I find that funds' investment in inside debt has performance implications: equity funds that underweight high-inside debt firms deliver positive alphas; in contrast, bond funds that overweight inside debt deliver higher alphas.