Bond Spreads and CDS-Bond Basis: Impact of Dodd-Frank Title VII

Abstract

This article explores recent regulatory impacts on the basis spread between an entity’s single-name Credit Default Swap (CDS) and its bond spread. This spread is commonly referred to as the CDS-bond basis. In 2010, Congress passed Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to regulate the over-the-counter (OTC) swap market. A major contribution of Title VII was that it added central clearing of OTC swaps, which intended to reduce counterparty risk and improve risk management practices in the swap market. After comparing results from before and after the initiation of central clearing of single-name CDS, we can make three contributions to the existing literature. First, counterparty default risk has less explanatory power as a driver of the CDS-bond basis after clearing is initiated. Second, CDS-bond basis spreads are higher following CDS clearing initiation. Last, bond spreads of the underlying entities of cleared, single-name CDS are lower after the initiation of central clearing. Results are robust to a control sample of non-cleared firms.