Credit Insurance, Distress Resolution Costs, and Bond Spreads

Financial Management, Forthcoming

36 Pages Posted: 21 Nov 2014 Last revised: 10 Mar 2018

See all articles by Rajesh Narayanan

Rajesh Narayanan

Louisiana State University

Cihan Uzmanoglu

Binghamton University, The State University of New York

Date Written: January 15, 2018

Abstract

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

Narayanan, Rajesh and Uzmanoglu, Cihan, Credit Insurance, Distress Resolution Costs, and Bond Spreads (January 15, 2018). Financial Management, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2528107 or http://dx.doi.org/10.2139/ssrn.2528107

Rajesh Narayanan

Louisiana State University ( email )

Baton Rouge, LA 70803-6308
United States
225-578-6236 (Phone)

Cihan Uzmanoglu (Contact Author)

Binghamton University, The State University of New York ( email )

Binghamton, NY 13902-6001
United States
607 777 66 38 (Phone)

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