CDS speculative attacks increase the risk of sovereign default in times of crisis; the same factors would apply to corporates.
New research by a trio of French academics challenges the belief that speculation in the credit default swap market does not influence bond spreads in countries with large sovereign debt markets. Published in the April issue of the Journal of International Money and Finance, the authors examined several European sovereign debt markets in the post-Lehman crisis period. They found evidence that the relationship between CDS premiums and bond spreads is not linear.
“This means that in times of market distress the much smaller CDS market could drive up the bond interest rates of sovereign nations, amplifying the crisis,” write the study’s authors – Anne-Laure Delatte of Rouen Business School, Mathieu Gex of the University of Grenoble, and Antonia López-Villavicencio of the University of Paris North. “The study showed that no country is safe from this perverse effect.”
The presupposition that CDS spreads move in a linear fashion with bond spreads in relation to a reference entity’s credit, and are not unduly affected by technical factors like speculative attacks, underlies banks’ argument for linking corporate loan pricing to CDS. Critics of such pricing linkage say that a lender that extends such a loan could manipulate the loan’s pricing via the CDS market.
The researchers concluded that the CDS used to speculate against the deteriorating conditions of sovereign states have a very perverse, self-fulfilling effect. While this seems obvious to many market observers, and applies to corporates as well, this research is the first to conclusively prove it.