Why Does Corporate Governance Explain Credit Spreads?

Abstract

This study explores a number of alternative explanations for the relation between credit spreads and governance. These include the overinvestment story in Li (2007), the information quality story of Duffie and Lando (2001) and an information asymmetry hypothesis based on the findings in Ferreira and Laux (2007). First, we find an economically weak negative relation between overinvestment and CDS spreads. This is consistent with Li (2007). Second, we find that credit spreads are increasing in information imprecision, as measured by analyst forecast errors. This is consistent with the notion that poor governance increases firms' disclosure quality and thus decreases credit spreads by the channel suggested in Duffie and Lando (2001). However, neither overinvestment nor information quality appear to explain the relation between governance and credit spreads. Finally, we find that proxies for liquidity in the CDS market are strongly related to CDS spreads. More significantly, we find that in the presence of our CDS market liquidity variables, the G-index has neither an economically nor statistically significant relation to CDS spreads. We argue, based on the findings in Ferreira and Laux (2007), that this consistent with the notion that the increased information production associated with low G-index firms makes bond dealers reluctant to post quotes for these firms, thereby reducing the liquidity of the CDS market and raising the level of the CDS spreads.