Do Credit Derivatives Lower the Value of Creditor Control Rights? Evidence from Debt Covenants

Abstract

We examine the impact of credit default swaps (CDS) on debt covenant design. CDS provide creditors with a way to protect their credit exposures in lieu of active monitoring, and they increase creditors’ bargaining power during debt renegotiations. Borrowers with CDS outstanding may in turn demand looser covenants to reduce the likelihood of costly renegotiations with tough creditors. Using contract-level data, we find that debt covenants are less strict if there are CDS contracts referencing the borrower’s debt at the time of loan initiation. This effect is robust to controls for endogeneity and selection bias, and it is stronger if the CDS market is deeper. Consistent with the tradeoffs between the costs and benefits of covenants, the covenant-loosening impact of CDS is concentrated among firms for whom agency and information problems are relatively less severe and those for whom renegotiations are expected to be more frequent. Our findings are consistent with the view that the creditor protection offered by CDS can substitute for protection through covenants, increasing the efficiency of debt contracting