Credit Default Swaps and Corporate Bond Trading

Abstract

Using regulatory data on CDS holdings and corporate bond transactions, I provide evidence for a liquidity spillover effect from CDS to bond markets. Bond trading volumes are larger for investors with CDS positions written on the debt issuer, in particular around rating downgrades. I use a quasi-natural experiment to validate these findings. I also provide causal evidence that CDS mark-to-market losses lead to fire sales in the bond market. I instrument for the prevalence of mark-to-market losses with the fraction of non-centrally cleared CDS contracts of an individual counterparty. The monthly corporate bond sell volumes of investors exposed to large mark-to-market losses are three times higher than those of unexposed counterparties. Returns decrease by more than 100 bps for bonds sold by exposed investors, compared to same-issuer bonds sold by unexposed investors. My findings underline the risk of a liquidity spiral in the credit market.