CDS Don't Spread Bankruptcy
The availability of credit insurance via credit default swaps (CDS) has had positive effects on corporate bond issuers, by increasing the liquidity of the corporate bond market, thus granting better funding opportunities. However, a number of scholars have recently advanced the hypothesis that the presence of CDS may favour the emergence of the so-called "empty creditors", i.e. a class of insured creditors whose interests may not be aligned with those of the remaining creditors in case of distress of the company.
In a CDS contract the protection buyer pays a periodic premium to the protection seller, and receives a settlement equal to the difference between the par and market value of the underlying debt of the reference entity should a default event occur. Typical default events include the bankruptcy of the debtor or the failure to pay principal / interests on the debt. Out-of-court debt renegotiations, instead, formally constitute credit events only under particular CDS restructuring clauses. In practice, no workout in the U.S. corporate segment has ever triggered a default in the CDS market, given the general disagreement about what constitutes a restructuring event. In such a context, a distressed debtor who attempts to convince its creditors to renegotiate the debt may find the opposition of those creditors who purchased insurance via CDS, who will find it optimal to push the company into formal bankruptcy (in order to obtain the payoff according to the CDS contract) even when an informal debt renegotiation would be more efficient.
In- and Out-of-Court Debt Restructuring in the Presence of Credit Default Swaps, a recent working paper by Mascia Bedendo (Department of Finace), Lara Cathcart and Lina El-Jahel (both Imperial College Business School), investigates from an empirical perspective whether the presence of CDS has had any impact in determining the outcome of the debt restructuring process for a number of reference entities during the 2008-2009 crisis. The study looks at all bankruptcy filings and distressed exchanges initiated by non-financial U.S. rated companies over the period January 2008 - December 2009. The research is aimed at highlighting any differences in the determinants of the restructuring method (distressed exchange vs. Chapter 11) between CDS reference entities and non-reference entities, and at testing whether the presence of CDS has increased the probability of filing for bankruptcy for reference entities.
The three main findings are the following. First, the authors do not find evidence that companies whose bondholders can purchase credit insurance via CDS are more likely to restructure their debt in court. In fact, the outcome of the debt renegotiation process seems to be driven by essentially the same variables for both reference entities and non-reference entities. Second, in agreement with previous literature on debt restructuring, firms that file for Chapter 11 report higher leverage ratios, higher short-term funding needs, and a larger proportion of secured debt than companies that reorganize out of court. Third, bankrupt firms in the recent crisis are characterized, on average, by a more simplified debt structure, mainly concentrated on bank loans. This evidence is consistent with the peculiarities of a financial crisis, where financial institutions are the first to be distressed, and may not be in a position to refinance their customers. In line with this explanation, we observe that the likelihood of filing for bankruptcy is positively related to the profitability shocks experienced by the main bank lenders of the firm.
Two reasons can explain the lack of evidence of "empty creditors". First, the proportion of insured bondholders is not sufficiently large to affect the outcome of the restructuring process in firms. Second, this proportion is large enough, however the insured bondholders prefer not to force the company into bankruptcy, due to either reputational issues or the uncertainty related to the bankruptcy process.