Shocks from the Subprime Crisis to Bond Indices in the U.S., the EU and Emerging Markets Via CDS Indices

Abstract

Extending Longstaff’s (2010) approach, this study uses the pre-, occurrence and persistent- periods of sub-prime crises in order to examine changes in global impulse responses, variance decompositions and contagion effects from the direct indices (i.e., ABX indices) of collateralised debt obligation (CDO), one kind of risky asset-backed securities (ABS), to the indices of credit default swaps (CDS). We then examine the similar approaches from CDS indices to associated bond indices. This paper is the first study to analyse the effects of shocks of financial crises on global bond markets through financial markets of risky ABS and CDS, simultaneously. These approaches are valuable because an investor buying a risky ABS tends to purchase a CDS to hedge the risks of the ABS, which then this CDS will transmit credit risks to capital markets. Our findings show significant impulse responses and contagion effects from lower-rated ABX index returns to associated CDS index returns, as opposed to higher-rated ABX index returns after a crisis occurs. During the outbreak of a crisis, a sharp increase in impulse responses from CDS index returns to bond index returns in emerging markets has been observed, as well as a larger rise in the variance ratio from CDS indices to Asian and NonAsian emerging market bond indices, as opposed to developed market bond indices. Thus, developed countries should stop rebalancing losses through securitization and recapitalization in emerging markets, in order to prevent a severe global financial crisis. Moreover, following the onset of the sub-prime crisis, there were more significant contagion effects from CDS indices in Asian emerging market bond indices, as opposed to developed markets. In the early stage of a crisis, credit risks significantly increase in Asian emerging market bond index returns. Hence, financial authorities in Asian emerging markets should avoid the risks of large investments in fixed income securities for investors after a crisis occurs.