Unlike their introduction into the established US and European bond markets, credit default swaps (CDS) began trading in Asia when its bond markets were still in their infancy. Contrary to evidence found in US data, CDS trading on bonds in Asia appears to lower the cost of and improve liquidity for new issuance. Smaller, nonfinancial firms and those with higher CDS trading liquidity benefit most from the presence of CDS.
What’s Inside?
Credit default swaps (CDS) can help improve some bond market inefficiencies—namely, asymmetric information, restriction on short sales (pricing and hedging), and low liquidity. Compared with the timing of their introduction into the already-established US and European bond markets, CDS were introduced to the Asian markets when they were still relatively small and less mature. The authors investigate how the introduction of CDS trading has affected the development of Asian bond markets. Specifically, they assess the effects of CDS trading on the cost of debt issuance, liquidity, and which issuers benefit most. They also address whether CDS trading affected the bond market in a new way during the recent financial crisis and comment on the policy implications of their findings.
How Is This Research Useful to Practitioners?
International investors, financial policymakers, and fixed-income and derivatives traders can all benefit from this research into the generally beneficial impact that CDS markets have on bonds. The authors find that, contrary to established research on US markets, CDS trading on bonds in Asia lowers the cost of new issuance and improves liquidity (likely via improved transparency and hedging opportunities). This difference relative to the US market can possibly be explained by the difference in the degree of financial market development (based on the theory that CDS draw attention and are thus invigorating Asian bond markets) or by the fact that a traded CDS may signal increased creditworthiness of the issuer.
The authors also find that smaller, nonfinancial firms and those with higher CDS liquidity reap the rewards of lower issuance cost and higher liquidity in secondary markets.
The stress during the recent financial crisis resulted in higher spreads (costs of up to 100 bps) for bonds whose firms are included in CDS indexes but no difference in their liquidity (besides that in the general market). The authors suggest that investors require additional payment for the risks visible in the CDS market or that the demand for CDS protection during the crisis increased CDS pricing, which, in turn, widened spreads on the actual bonds.
Considering that CDS can lower costs and improve liquidity in the bond market as well as cause widening spreads in turmoil or crisis, over and above the general widening of spreads, financial regulators are encouraged to strike the right balance between expanding CDS markets in Asia and implementing more rigorous supervision.
How Did the Authors Conduct This Research?
The authors use bond (Bloomberg) and CDS (Markit) data for 1,091 senior bonds from 263 firms in five markets over 6.5 years, from January 2003 through June 2009. Although the authors use the term “Asia” in their title and throughout their paper, the majority of data come from Japan and Korea, with only a small representation from Hong Kong, Malaysia, and Singapore. They initiate research on 10 economies, including China, India, Indonesia, the Philippines, and Thailand, but exclude these economies from their study because of limited data.
They evaluate the impact of CDS on bond issuance cost by measuring the bond spread over similar local government issues and on liquidity by evaluating the bid–ask spread. They implement a cross-sectional regression analysis for firms with and without CDS and extend that regression to determine which bond types benefit by incorporating dummy variables, including firm size and leverage, among others. They also make a concerted effort to control for selection bias because some firms are able to delay their issuance of debt until markets are more favorable.
Abstractor’s Viewpoint
The authors contribute a robust analysis to identify a different reaction to CDS markets in a region with less mature bond markets. I would have suggested that they narrow their research and publish data for each individual country before trying to draw conclusions for the whole “Asian” region.