CDS and the Liquidity Provision in the Bond Market

Abstract

We study the effect of credit default swap (CDS) on the corporate bond market. We argue that CDS, by reducing the need of investors to liquidate the bonds in the face of credit deterioration of the issuer, reduces fire sale risk and provides bond liquidity. Given that bond investors are segmented by regulation – i.e., insurance companies, banks, and pension funds are subject to the risk-based capital requirements and in principle only hold high quality assets, – we expect the liquidity provision role of CDS to be concentrated among investment grade bonds. We test this hypothesis using a comprehensive sample of US corporate bonds with CDS contracts information over the 2001-2009 period. We show that the presence of CDS reduces yield spreads and increases liquidity for investment grade bonds. This effect is stronger during the financial crisis period. We provide a proper instrumental variable identification that pins down the need for CDS contracts by exploiting the level of loan concentration of the banks which the bond issuer borrows from. We also examine two events that have been shown to trigger forced sales by bond investors: bond rating downgrades from investment grade to high yield, and the selling pressure of property insurance companies following Hurricane Katrina. In both cases, the presence of CDS contracts lowers the impact of fire sales by reducing the drop in bond liquidity and the rise in yield spreads. Our results have important normative implications, as they suggest that – at least for the class of investment grade bonds – CDS may actually help to reduce risk contagion around financial crises.