The Equilibrium Effects of Credit Default Swaps on Bond Markets
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Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets ∗ Martin Oehmke y Adam Zawadowski z Columbia University Boston University June 29, 2014 Abstract We provide a model of non-redundant credit default swaps (CDSs), building on the observation that CDSs are more liquid than bonds. CDS introduction involves a trade-off: It crowds out demand for the bond, but improves the bond allocation because it allows long-term investors to become levered basis traders. CDS introduction raises bond prices only when there is a significant liquidity difference between bond and CDS (both across and within firms). Our framework predicts a negative CDS-bond basis, turnover and price impact patterns that are consistent with empirical evidence, and shows that a ban on naked CDSs can raise borrowing costs. ∗For helpful comments and suggestions, we thank Jennie Bai, Snehal Banerjee, Patrick Bolton, Willie Fuchs, Haitao Li, Xuewen Liu, Konstantin Milbradt, Uday Rajan, Suresh Sundaresan, Dimitri Vayanos, and Haoxiang Zhu, as well as conference and seminar participants at the 2013 Red Rock Conference, 2014 AFA Annual Meeting (Philadelphia), Boston University, Brandeis University, BIS, Vienna GSF, Singapore Management University, Nanyang Technological University, National University of Singapore, HKUST, Humboldt Universit¨atzu Berlin, Columbia University, Michigan State University, Wharton, the Boston Fed, the 2014 SFS Calvacade, LSE, and the 2014 WFA. yColumbia Business School, 420 Uris Hall, 3022 Broadway, New York, NY 10027, e-mail: [email protected], http://www0.gsb.columbia.edu/faculty/moehmke zBoston University School of Management, 595 Commonwealth Avenue, Boston, MA 02215, e-mail: [email protected], http: //www.people.bu.edu/zawa 1 Introduction Credit Default Swap (CDS) markets have grown enormously over the last decade. However, while there is a relatively large literature on the pricing of CDSs, much less work has been done on the economic role of these markets. For example, in most pricing models, CDSs are redundant securities, such that the introduction of a CDS market has no effect on the underlying bond market. This irrelevancy feature makes a meaningful analysis of the economic role of CDS markets difficult. In this paper, we develop a theory of non-redundant CDS markets, building on a simple, well- documented empirical observation: Trading bonds is expensive relative to trading CDSs. Based on this observation, we develop a theory of the interaction of bond and CDS markets and the economic role of CDSs. Our model provides an integrated framework that matches many of the stylized facts in bond and CDS markets: the effect of CDS markets on the price of the underlying bond (and therefore financing cost for issuers), the relative pricing of the CDS and the underlying bond (the CDS-bond basis), and trading volume in the bond and CDS markets. Our model also provides a tractable framework to assess policy interventions in CDS markets, such as the recent E.U. ban of naked CDS positions. In our model, investors differ across two dimensions. First, investors differ in their investment horizons: Some investors are unlikely to have to sell their position in the future and are therefore similar to buy-and-hold investors, such as insurance companies. Other investors are more likely to receive liquidity shocks and therefore have shorter investment horizons. These investors can be interpreted as active traders, such as speculators or hedge funds. Second, investors have heterogeneous beliefs about the bond's default probability: Optimistic investors view the default of the bond as unlikely, while pessimists think that a default is relatively more likely. If only the bond is traded, relatively optimistic investors with sufficiently long trading horizons buy the bond, whereas relatively pessimistic investors with sufficiently long trading horizons take short positions in the bond. Investors with short 1 investment horizons stay out of the market, because for them the transaction costs of trading the bond are too high. The introduction of a CDS affects the underlying bond market through three effects: (1) Some investors who previously held a long position in the bond switch to selling CDS protection, putting downward pressure on the bond price. (2) Investors who previously shorted the bond switch to buying CDS protection because, in equilibrium, the relatively illiquid bond trades at a discount compared to the CDS. The resulting reduction in short selling puts upward pressure on the bond price. (3) Some investors become \negative basis traders" who hold a long position in the bond and purchase CDS protection (i.e., the model endogenously generates the negative basis trade, which has been an immensely popular trading strategy in recent years). If basis traders cannot take leverage, they do not affect the price of the underlying bond. If basis traders can take leverage|a natural assumption given that they hold hedged positions|they push up the bond price. In practice, basis trades are often highly levered and their leverage varies with financial conditions, leading to time-series variation in the strength of this third effect. Taken together, these three effects imply that, in general, CDS introduction is associated with an ambiguous change in the price of the underlying bond. This prediction is consistent with the empirical literature, which has found no unconditional effect of CDS introduction on bond or loan spreads (Hirtle (2009), Ashcraft and Santos(2009)). More importantly, our model identifies the underlying economic trade-off that determines the effect of CDS introduction. One the one hand, CDS introduction can crowd out demand for the bond, while on the other hand it leads to an allocational improvement in the bond market, because the presence of the CDS allows long-term investors to hold more of the bond supply. The balance of this trade-off critically depends on the relative liquidity of the bond and the CDS: When the bond and the CDS are similar in terms of their liquidity, the crowding out effect dominates and CDS introduction lowers bond prices. On the other hand, when there is a substantial difference in the liquidity of the CDS and the underlying bond, the introduction of the CDS tends to raise bond prices. The same logic implies that, for firms with multiple bond issues of 2 differing liquidity (e.g., \on-the-run" and “off-the-run” bonds), illiquid bonds benefit relatively more from CDS introduction. In fact, the price effect of CDS introduction can go in opposite directions for bonds of differing liquidity issued by the same company; the price of the illiquid bond increases while the price of the liquid bond decreases. The endogenous emergence of leveraged basis traders highlights a novel economic role of CDS markets: The introduction of a relatively more liquid derivative market allows buy-and-hold investors, who are efficient holders of the illiquid bond, to hedge undesired credit risk in the more liquid CDS market. In the CDS market, the average seller of CDS protection is relatively optimistic about the bond's default probability, but is not an efficient holder of the bond because of more frequent liquidity shocks. The role of CDS markets is thus similar to liquidity transformation|by repackaging the bond's default risk into a more liquid security, they allow the transfer of credit risk from efficient holders of the bond to relatively more optimistic shorter-term investors, such as hedge funds. Hence, when bonds are illiquid, a liquid CDS can improve the allocation of credit risk and thus presents an alternative to recent proposals that aim at making the corporate bond market more liquid, for example through standardization.1 This liquidity view of CDS markets differs from the traditional view that the main function of CDSs is simply the separation of credit risk and interest rate risk.2 However, because the separation of interest rate risk from credit risk is also possible via a simple interest rate swap, it is unlikely that this traditional view captures the full economic role of CDS markets. Beyond the price effects of CDS introduction, our model generates testable predictions regarding trading volume in bond and CDS markets that are consistent with recent empirical evidence. First, our model predicts that CDS turnover is higher than bond turnover, which is consistent with the evidence in Oehmke and Zawadowski(2013), who show that average monthly CDS turnover is around 50%, whereas average monthly turnover in the associated bonds is around 7.5%. Second, consistent with the findings of Das, Kalimipalli, and Nayak(2014), our model predicts that CDS introduction decreases turnover in the underlying bond. Third, despite this decrease in turnover, CDS introduction can reduce 1Standardized bonds were recently proposed by the investment management firm BlackRock (BlackRock(2013)). 2See, e.g., the \Credit Derivatives Handbook" (JPMorgan(2006)). 3 price impact in the bond market, such that, consistent with Das, Kalimipalli, and Nayak(2014), the effect of CDS introduction on bond market liquidity can differ depending on which particular illiquidity measure is used. From an asset pricing perspective, the prediction that the equilibrium price of the bond is (weakly) less than the price of a synthetic bond consisting of a risk-free bond and a short position in the CDS replicates a well-documented empirical phenomenon known as the negative CDS-bond basis (see, e.g., Bai and Collin-Dufresne(2010) and Fontana(2011)). Here our model generates a number of predictions regarding both the time-series and cross-sectional variation in the CDS-bond basis: The basis is more negative if the bond is more illiquid, when there is more disagreement about the bond's default probability, and when basis traders are restricted in the amount of leverage they can take. Finally, our model provides a framework to study regulatory interventions with respect to CDS markets.