Debt Restructuring Costs and Bankruptcy Risk: Evidence from CDS Spreads

We examine the effects of a recent change to the US tax code that reduced the costs lenders incur when restructuring loans out of court (Regulation TD9599). The regulation contemplated particular types of loans, allowing us to use a triple-differences approach to identify the degree to which borrowers are differentially affected by the shift in restructuring costs. We model these changes and show how CDS market responses allow us to disentangle the relative costs of in-court versus out-of-court restructuring. Our evidence is consistent with markets anticipating more out-of-court workouts after the passage of TD9599. CDS spreads decline by record-low figures on the regulation’s announcement and the drop is concentrated among distressed firms with high syndicated loans-to-total debt ratios — those borrowers most affected by the reduction in renegotiation costs. Stock returns of these distressed firms as well as of their syndicate lenders outperform the market on the announcement of TD9599. As a result of the reduction in bankruptcy likelihood, distressed firms’ access to syndicated loans expands and their financing costs decline. Our analysis provides insights into how altering regulatory constraints can improve welfare in financial distress.