Credit Insurance, Distress Resolution Costs, and Bond Spreads
Rajesh Narayanan and
Financial Management, 2018, vol. 47, issue 4, 931-951
Credit default swaps (CDS) introduce friction in debt renegotiations as they alter the incentives of creditors insured with CDS to favor bankruptcy instead of restructuring debt out of court. Such renegotiation friction 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 this increase 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.
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