Aurora Borealis
7 June 2018 CFA Institute Journal Review

Credit Default Swaps and Firms' Financing Policies (Digest Summary)

  1. Marc L. Ross, CFA
Credit default swaps (CDS) affect the capital structure and trade credit policy of the underlying firms whose debt CDS trade and that issue large amounts of long-term debt. The authors demonstrate that, compared with firms on whose debt CDS do not trade, such firms are more likely to decrease debt financing in favor of greater equity issuance. These same firms collect from customers and pay suppliers more quickly.

How Is This Research Useful to Practitioners?

A hedging tool for creditors, credit default swaps (CDS) have grown in significance in US financial markets. Their presence has ignited controversy—in particular, how CDS may affect capital structure (e.g., debt versus equity) and trade credit policy (e.g., accounts payable and accounts receivable) of the firms underlying the CDS. CDS instruments, by extension, can affect a firm’s risk profile.

The authors examine whether underlying firms of CDS issue more (less) long-term and short-term debt but less (more) equity and whether such firms increase or decrease their trade credit. Model estimations examine the influence of CDS trading on firms’ financing and trade credit policies and risk profiles.

CDS trading on firms’ debt, according to the authors, affects those firms’ financing decisions and long-term capital structure choices. Such firms increase net equity issuance. CDS trading also positively correlates with total and firm-specific risk. Additionally, firms on whose debt CDS are issued and trade tend to more quickly settle accounts payable and collect accounts receivable.

How Did the Authors Conduct This Research?

The sample consists of US CDS data reported on Bloomberg from 2002 to 2016. Other data come from Compustat and CRSP. The sample excludes firms with total assets below $10 million and with a negative market value of equity. Variables at 1% and 99% are winsorized to avoid outlier bias.

The authors construct models to assess the influence of CDS trading on a firm’s debt. These models include specifications to simulate firms’ corporate finance policies (e.g., the choice of debt or equity), to model how CDS contracts affect firms’ risk profiles, and to gauge the effect of CDS on these firms’ management of their trade credit. The models control for the impact of such factors as cash flows, financial distress, market conditions, and operating profitability on firms’ financing and trade credit decisions.

Univariate and multivariate analyses confirm that a positive relationship exists between CDS trading on a firm’s debt and the greater propensity to issue equity instead of debt compared with firms on whose debt CDS do not trade. This condition is amplified for less liquid firms. The effect of CDS on debt financing on long-term debt issuance appears to be nonlinear; firms with low (high) percentages of long-term debt may (not) substitute it with equity. CDS trading appears to influence firms’ longer-term, rather than shorter-term, financing decisions. Finally, firms on whose debt CDS trade tend to exhibit greater firm-specific risk and total risk.

The influence of CDS trading on firms’ exercise of trade credit is also nonlinear. With an increase in CDS traded on firms’ debt comes an increase in accounts payable and receivable ratios. Some firms may decrease their long-term issuance because of the influence of CDS and collect receivables more quickly as a result.

Abstractor’s Viewpoint

The reach of the CDS market appears long, and the nature of these instruments’ influence remains controversial. An insurance-like device to manage bondholders’ risk, CDS influence such balance sheet decisions as capital structure choice and trade credit policy. These choices can materially affect firms’ total and idiosyncratic risks. Indeed, if CDS trading on a firm impels it to issue more equity, then the firm’s cost of capital will increase. Further, CDS appear to exert a second-order effect on the customers of firms on whose debt the contracts trade: CDS firms opting for equity and curtailing long-term debt issuance may collect their receivables and satisfy their payables more quickly compared with non-CDS firms. Extending the authors’ research to non-US markets could be a worthwhile exercise to determine whether the contracts exert a similar influence in different financial markets.

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