Jumps in Credit Default Swap Spreads and Stock Returns

Abstract

The authors examine the impact of large changes in singleissuer credit default swap (CDS) spreads on the underlying entity’s equity prices. They consider a sample of 633 significant credit events (or CDS spread changes) relating to 295 U.S. nonfinancial corporations between April 2005 and March 2008. The results indicate that during the period leading up to the financial crisis, equity returns respond positively to both credit widening and contracting events. The evidence during the pre-crisis period supports the view that equity investors do not perceive debt-deteriorating events to be necessarily value-deteriorating for shareholders. In contrast, during the financial crisis period, the authors observe an entirely inverse relationship between CDS spread jumps and equity price movements, particularly for firms with speculative-grade bonds. The findings support the conclusion that the relationship between equity and credit markets is regime dependent and that stock prices seem to anticipate changes from widening CDS spreads.