Does liquidity spill over in the credit market? The case of CDS and corporate bonds

Robert Czech

Credit default swaps (CDS) have a notoriously bad reputation. Critics refer to CDS as a “global joke” that should be “outlawed”, not at least due to the opaque market structure. Even the Vatican labelled CDS trading as “extremely immoral”. But could there be a brighter side to these swaps? In theory, CDS contracts can reduce risks in financial markets by providing valuable insurance. In a recent paper, I show that CDS also offer another, more subtle benefit: an increase in the liquidity of the underlying bonds.

Background

The CDS market is one of the most important venues for credit risk transfer. CDS are usually more liquid than corporate bonds – despite a significant decline in single name CDS activity since the financial crisis. Banks and insurance companies use CDS contracts to hedge their credit risk and free up regulatory capital. CDS also allow investors to “juice-up” the yields of their portfolio. Hence it’s obvious why CDS carry valuable benefits for investors. But can CDS also benefit bond issuers, i.e. real economy firms?

Sambalaibat (2018) sheds some light on how such benefits can arise. The presence of CDS markets leads to a liquidity spillover effect: a greater number of bond buyers and larger bond trading volumes. In theory, the result is a more liquid bond market and cheaper borrowing costs for firms in the real economy.

I provide the first empirical evidence for these predictions using two rich regulatory datasets. I combine data on single name CDS positions from the DTCC Global Trade Repository (GTR) with data on corporate bond transactions from the Financial Conduct Authority’s Zen database. The great advantage of the regulatory data is that I observe the identity of both counterparties for most trades. This allows me to match corporate bond transactions with single name CDS positions (if any) for each investor in my sample.

Liquidity spillovers

To analyse the relationship between CDS positions and corporate bond trading, I regress bond trading volumes on indicator variables for CDS buyers and CDS sellers. I run monthly regressions for each investor-reference entity combination, controlling for any unobserved investor or issuer characteristics.

The results are highly statistically significant. I find that investors with active CDS contracts on a particular firm have 60% higher buy volumes in the bonds of this issuer, compared to non-CDS counterparties.

The effect is particularly pronounced around rating downgrades, when CDS counterparties act in a “countercyclical” fashion by increasing their buy volumes in the bonds of the downgraded issuers.

My results echo recent industry studies claiming that a more liquid single name CDS market would have positive knock-on effects on corporate bond market liquidity. The improved bond market liquidity ultimately reduces risks for investors by allowing them to trade on demand, which in turn reduces borrowing costs for firms in the real economy.

Impact of recent regulations

But are these findings just correlations? Intuitively, it is possible that transactions in the corporate bond market determine the composition of an investor’s CDS portfolio, and not the other way round.

I use the regulatory reform of over-the-counter (OTC) derivatives in March 2015 to establish a causal relationship. The new regulation aims to reduce systemic risk in the OTC derivatives market by increasing margin requirements. The new rules are being gradually implemented, starting with large dealer banks. These banks saw an increase in CDS trading costs, relative to smaller investors not yet affected by the new regulation. I exploit this variation in CDS trading costs for a difference-in-difference analysis.  

Dealer banks chose to exit numerous CDS positions in response to the increase in trading costs. The dealers’ exit from these CDS positions is associated with a 113% increase in sell volumes and a 54% drop in buy volumes in the bonds of the underlying firms, indicating that dealer banks sharply reduced their bond holdings for these issuers (Chart 1).

Chart 1: Dealer banks’ bond trading volumes in response to more stringent margin requirements

These results underline the positive relation between CDS positions and bond trading volumes, lending strong support to the liquidity spillover hypothesis. They are also in line with anecdotal evidence of a drop in bond market liquidity following the ban of “naked CDS” positions in the European Union in 2011.

Fire-sale risks

But the criticism of CDS trading is not unjustified despite these positive spillovers. “Manufactured” credit events, in which solvent companies are encouraged to default on their debt in return for favourable financing terms, are a prominent example for questionable practices in the market. Regulators have identified this key issue and started collaborative efforts to discourage such opportunistic strategies.

My paper sheds light on another important source of risk: could a downturn in the CDS market have a negative impact on the prices and liquidity of corporate bonds? I show that losses on CDS positions force distressed investors into fire sales to obtain liquidity. The monthly bond sell volumes of investors exposed to severe CDS losses are three times higher than those of unexposed counterparties. The distressed investors are more likely to sell liquid and better-rated bonds, hence reducing the liquidity of their bond portfolios.

The fire sales also have a significant impact on bond prices. Returns decrease by more than 100 basis points for bonds whose sellers are exposed to large losses, compared to bonds of the same issuer sold by unexposed investors (Chart 2). The returns slowly recover over several months, which confirms that the price drops are not driven by any changes in bond fundamentals. My findings therefore underline the risk of a liquidity spiral in the credit market.

Chart 2: Cumulative returns of bonds sold by distressed investors

Financial stability implications

A liquid and accessible CDS market enhances trading volumes and market-making in the secondary corporate bond market. CDS investors provide liquidity and help to stabilise the bond market around rating downgrades, partly absorbing the fire sales of constrained investors (such as insurance companies).

However, the positive liquidity spillovers need to be balanced against potential risks for the corporate bond market that can originate from severe losses on CDS positions.

Robert Czech works in the Bank’s Capital Markets Division.

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