Credit Insurance, Distress Resolution Costs, and Bond Spreads
Financial Management, Forthcoming
36 Pages Posted: 21 Nov 2014 Last revised: 10 Mar 2018
Date Written: January 15, 2018
Credit default swaps (CDS) introduce frictions in debt renegotiations because they alter the incentives of creditors insured with CDS to favor bankruptcy instead of restructuring debt out-of-court. Such renegotiation frictions can increase bond spreads by increasing distress resolution costs. Alternatively, they can decrease bond spreads by deterring the firm from strategic default. Using newly available data on firm-level CDS positions to proxy for the extent of CDS insurance, we find that bond spreads increase with CDS insurance. Additional tests indicate that the increase in spreads is associated with the effect CDS insurance has on increasing distress resolution costs. These results, which are robust to endogeneity concerns associated with CDS insurance, provide evidence that credit insurance can affect a firm’s cost of debt.
Keywords: Credit default swaps (CDS); net notional; bond spreads; cost of debt; debt contracting; bankruptcy; strategic default
JEL Classification: G30; G32; G33; G34
Suggested Citation: Suggested Citation