Credit Default Swaps and Credit Risk Reallocation

Using granular data on both debt and credit default swaps (CDS) exposures by French investors on non-financial corporations (NFC) and euro area banks on French NFCs, we study how CDS reallocate investors' exposure to credit risk. To guide our investigation, we propose a methodology to disentangle investors' strategies between speculators, hedgers, and arbitrageurs. We make three contributions. First, CDS reduce exposure concentration. Hedgers offset their most concentrated exposures while speculators use them as a substitute for debt. Second, speculators use CDS to reach for yield both between and within rating classes. This could pertain to relatively lower leverage constraints at lower ratings, or to the opacity advantage of CDS. Finally, CDS increase investment funds and dealers portfolio risk. Both reach for yield and exposure diversification contribute to this rise. Exposure diversification in the CDS market thus does not translate into return diversification.