Hedging risky corporate bonds with credit default swaps is nothing new. It’s a practice that investors have used to protect themselves from default for some time.
But a new report out of The New York Fed’s Liberty Street Economics shows a surprising derivative effect from these CDS payments: they may actually lead the company to bankruptcy.
At issue is what they call “empty creditors,” or investors who have hedged their positions with swaps, so they no longer care if the company can restructure out of bankruptcy protection. In some cases, the creditors can even benefit from bankruptcy.
Stavros Peristani found firms exposed to credit default swaps fell to bankruptcy at 13 to 36 per cent higher rates that similarly risky investments (the third column of the chart below). Peristani also found that the problem grew significantly around the time of the financial crisis.
Below, the table with his full results.
Photo: Liberty Street Economics