How Cost Stickiness Affects Credit Risk

In this paper, we document strong evidence for an impact of asymmetric cost behavior – more precisely cost stickiness – on credit risk. An increase by one standard deviation in (aggregate) cost stickiness leads to a 27 basis points increase in Credit Default Swap (CDS) spreads on average, which equals an increase in cost of debt by 27 basis points. This finding holds for CDS on both senior and subordinated debt of all maturities and is most pronounced for short-term spreads, which is consistent with structural credit model expectations. Analyzing the relation in more detail, we show that cost stickiness caused by inflexibility in cost adjustment – measured by an employee protection law – is positively and significantly related to corporate credit risk. In contrast, stickiness arising in firms with high flexibility in cost adjustment decreases corporate credit risk. Consistently, we also find different effects across different cost categories. For sticky R&D costs, which are highly flexible, we find a decrease in CDS spreads by nearly 100 basis points. In contrast, sticky operating costs, which due to a higher fix cost portion are less flexible, increase CDS spreads by 48 basis points.