Credit Default Swaps, Strategic Default, and the Cost of Corporate Debt

Abstract

When the firm writes incomplete debt contracts, its limited ability to commit not to strategically default and renegotiate on its debt requires the firm to pay higher yields to its creditors. Hedged by credit derivatives, creditors come to have stronger bargaining power in case of debt renegotiation, which ex-ante demotivates the firm to default strategically. In this paper, I aim to test whether credit derivatives could help reduce the cost of debt contracting stemming from the possibility of strategic default. I find that firms with a priori high strategic default incentives experience a relatively large reduction in their corporate bond yields after the introduction of credit default swaps (CDS) written on their debt. This result is robust to controlling for the endogeneity of CDS introduction. My finding is consistent with the presence of CDS reducing the strategic-default-related cost of corporate debt, suggesting the beneficial role of credit derivatives as a commitment device for the borrower to repay the lender as proposed in Bolton and Oehmke (2011).