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Abstract: 

Credit default swaps (CDSs) have important implications for fixed income investors, but at the moment, we know little about their implications for bond issuers. Research on the corporate bond market suggests CDS prices convey special information about credit risk, which makes price discovery more efficient and ultimately lowers issuers’ borrowing costs. The purpose of this paper is to determine if CDSs convey similar benefits to municipal bond issuers. This paper asks two questions: What factors determine the cost of municipal CDSs, and do those costs affect borrowing costs on new municipal debt issues? The author finds that, unlike credit ratings, municipal CDS prices are driven largely by factors that issuers can influence. He also finds that, perhaps surprisingly, an increase in the price of default protection decreases borrowing costs on new bond issues. Taken together, these findings suggest that, on balance, CDSs are adding value to public debt management.

Keywords: credit derivatives, management quality, legacy costs, credit protection, issuer-specific municipal credit risk, premium to yield ratio, Regression Estimates

Affiliations:  1: University of Washington.