Cost Structure, Operating Leverage, and CDS Spreads

We provide evidence that credit investors do not fully impound the implications of firms' cost structure (or operating leverage) when pricing credit default swaps. Information about firms' cost structure is not disclosed and needs to be estimated. Furthermore, the performance implications of firms' cost structure depend on the expected macroeconomic conditions. We focus on the debt market because of the strong emphasis of this market on downside risk. To measure expected aggregate macroeconomic conditions, we employ the change in the anxious index (AI), which is the probability of a decline in real GDP provided by the SPF-the survey of professional forecasters. We find that the interaction between the firm's cost structure and change in AI predicts one-quarter-ahead CDS spreads. Portfolio-level analysis confirms this result.