Sovereign credit spreads

The paper develops a structural credit risk model to study sovereign credit risk and the dynamics of sovereign credit spreads. The model features endogenous default and recovery rates that both depend on the interaction between domestic output fluctuations and global macroeconomic conditions. We show that sovereigns choose to default at higher levels of economic output once global macroeconomic conditions are bad. This yields to default rates and credit spreads that are substantially higher compared to normal times. We derive closed-form expressions for sovereign debt values and default times and focus on the dynamics of sovereign credit spreads. As opposed to standard theories of sovereign debt, this paper’s structural model generates much richer default patterns and non-linearities through regime-shifts in the global macroeconomic environment. Moreover, changes in the global environment reveal the interconnectedness of the financial system.     

Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.     

Daily pricing of emerging market sovereign CDS before and during the global financial crisis

In this paper, we study the determinants of daily spreads for emerging market sovereign credit default swaps (CDSs) over the period April 2002–December 2011. Using GARCH models, we find, first, that daily CDS spreads for emerging market sovereigns are more related to global and regional risk premia than to country-specific risk factors. This result is particularly evident during the second subsample (August 2007–December 2011), where neither macroeconomic variables nor country ratings significantly explain CDS spread changes. Second, measures of US bond, equity, and CDX High Yield returns, as well as emerging market credit returns, are the most dominant drivers of CDS spread changes. Finally, our analysis suggests that CDS spreads are more strongly influenced by international spillover effects during periods of market stress than during normal times.     

Downside risk and the size of credit spreads

We investigate why spreads on corporate bonds are so much larger than expected losses from default. Systematic factors make very little contribution to spreads, even if higher moments or downside effects are taken into account. Instead we find that sizes of spreads are strongly related to idiosyncratic-risk factors: not only to idiosyncratic equity volatility, but even more to idiosyncratic bond volatility and idiosyncratic bond value-at-risk. Idiosyncratic bond volatility helps to explain spreads because it reflects not just the distribution of firm value but is also a proxy for liquidity risk. Idiosyncratic bond value-at-risk adds to this by capturing the left-skewness of the firm-value distribution. We confirm our results both for the initial 1997-2004 sample period and also out of sample for 2005-2009, which includes the sub-prime crisis. Overall, credit spreads are large because they incorporate a large risk premium related to investors’ fears of extreme losses.     

Market conditions,default risk and credit spreads

This study empirically examines the impact of the interaction between market and default risk on corporate credit spreads. Using credit default swap (CDS) spreads, we find that average credit spreads decrease in GDP growth rate, but increase in GDP growth volatility and jump risk in the equity market. At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads generally rise with cash flow volatility and beta, with the effect of cash flow beta varying with market conditions. We identify implied volatility as the most significant determinant of default risk among firm-level characteristics. Overall, a major portion of individual credit spreads is accounted for by firm-level determinants of default risk, while macroeconomic variables are directly responsible for a lesser portion.     

Liquidity,default, taxes,and yields on municipal bonds

We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model includes liquidity as a state factor. Using a unique transaction dataset, we estimate the liquidity risk of municipals and its effect on bond yields. Empirical evidence shows that municipal bond yields are strongly affected by all three factors. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium accounts for about 9–13% of municipal yields for AAA bonds, 9–15% for AA/A bonds and 8–19% for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in a severe underestimation of municipal bond yields. Conditional on the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and institutional investors. Furthermore, these implicit income tax rates are quite stable across bonds of different maturities. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle.     

Capital structure,credit risk,and macroeconomic conditions

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.     

Macroeconomic Forces and Mutual Fund Betas

This paper develops and tests a model in which fund betas are linearly related to changes in macroeconomic factors. Tests using monthly returns for 171 mutual funds over 1978–1991 were run. Results indicate that equity funds betas, on average, are negatively related to inflation changes and default risk premia while bond fund betas, on average, are negatively related to changes in risk-free rates, industrial production growth, and the term structure. Betas for passive portfolios, however, are not related to the macroeconomic factors examined.     

The term structure of sovereign default risk in EMU member countries and its determinants

We analyze the determinants of sovereign default risk of EMU member states using government bond yield spreads as risk indicators. We focus on default risk for different time spans indicated by spreads for different maturities. Using a panel framework we analyze whether there are different drivers of default risk for different maturities. We find that lower economic growth and larger openness increase default risk for all maturities. Higher indebtedness only increases short-term risk, whereas net lending, trade balance and interest rate costs only drive long-term default risk.     

Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market

We use the information in credit default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads. We find that the majority of the corporate spread is due to default risk. This result holds for all rating categories and is robust to the definition of the riskless curve. We also find that the nondefault component is time varying and strongly related to measures of bond‐specific illiquidity as well as to macroeconomic measures of bond market liquidity.     

Exploring the components of credit risk in credit default swaps

In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.     

A set-valued Markov chain approach to credit default

We propose a novel credit default model that takes into account the impact of macroeconomic factors and intergroup contagion on the defaults of obligors. We use a set-valued Markov chain to model the default process, which includes all defaulted obligors in the group. We obtain analytic characterizations for the default process and derive pricing formulas in explicit forms for synthetic collateralized debt obligations (CDOs). Furthermore, we use market data to calibrate the model and conduct numerical studies on the tranche spreads of CDOs. We find evidence to support that systematic default risk coupled with default contagion could have the leading component of the total default risk.     

A Multifactor Model of Credit Spreads

We represent credit spreads across ratings as a function of common unobservable factors of the Vasicek form. Using a state-space approach we estimate the factors, their process parameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of structural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also contribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a systematic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to macroeconomic variables. This suggests that if credit spread levels do contain a large liquidity premium, the time variation of this premium is likely driven by the same factors as default risk.     

Correlation in credit risk changes

The current economic climate makes understanding credit risk correlation particularly important. After allowing for a comprehensive set of observable firm-specific, industry, market, and macroeconomic factors, there is an economically significant co-movement in credit default swap spreads that remains to be explained. Including a time dummy completely accounts for the remaining co-movement, confirming the existence of a systematic component that has been previously unaccounted for. Our findings suggest that it may be important to consider unobservable risk factor(s) in credit risk models.     

Corporate credit risk modeling and the macroeconomy

Despite a surge in the research efforts put into modeling credit and default risk during the past decade, few studies have incorporated the impact that macroeconomic conditions have on business defaults. In this paper, we estimate a duration model to explain the survival time to default for borrowers in the business loan portfolio of a major Swedish bank over the period 1994–2000. The model takes both firm-specific characteristics, such as accounting ratios and payment behaviour, loan-related information, and the prevailing macroeconomic conditions into account. The output gap, the yield curve and consumers’ expectations of future economic development have significant explanatory power for the default risk of firms. We also compare our model with a frequently used model of firm default risk that conditions only on firm-specific information. The comparison shows that while the latter model can make a reasonably accurate ranking of firms’ according to default risk, our model, by taking macro conditions into account, is also able to account for the absolute level of risk.     

Corporate Yield Spreads and Bond Liquidity

We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond‐specific, firm‐specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.     

Corporate bond default risk: A 150-year perspective

We study corporate bond default rates using an extensive new data set spanning the 1866-2008 period. We find that the corporate bond market has repeatedly suffered clustered default events much worse than those experienced during the Great Depression. For example, during the railroad crisis of 1873-1875, total defaults amounted to 36% of the par value of the entire corporate bond market. Using a regime-switching model, we examine the extent to which default rates can be forecast by financial and macroeconomic variables. We find that stock returns, stock return volatility, and changes in GDP are strong predictors of default rates. Surprisingly, however, credit spreads are not. Over the long term, credit spreads are roughly twice as large as default losses, resulting in an average credit risk premium of about 80 basis points. We also find that credit spreads do not adjust in response to realized default rates.     

Liquidity risk of corporate bond returns: conditional approach

We study the exposure of the US corporate bond returns to liquidity shocks of stocks and Treasury bonds over the period 1973–2007 in a regime-switching model. In one regime, liquidity shocks have mostly insignificant effects on bond prices, whereas in another regime, a rise in illiquidity produces significant but conflicting effects: Prices of investment-grade bonds rise while prices of speculative-grade (junk) bonds fall substantially (relative to the market). Relating the probability of these regimes to macroeconomic conditions we find that the second regime can be predicted by economic conditions that are characterized as “stress.” These effects, which are robust to controlling for other systematic risks (term and default), suggest the existence of time-varying liquidity risk of corporate bond returns conditional on episodes of flight to liquidity. Our model can predict the out-of-sample bond returns for the stress years 2008–2009. We find a similar pattern for stocks classified by high or low book-to-market ratio, where again, liquidity shocks play a special role in periods characterized by adverse economic conditions.     

Default and Recovery Risk Dependencies in a Simple Credit Risk Model

This paper provides evidence for the relationship between credit quality, recovery rate, and correlation. The paper finds that rating grade, rating shift, and macroeconomic factors provide a highly significant explanation for default risk and recovery risk of US bond issues. The empirical data suggest that default and recovery processes are highly correlated. Therefore, a joint approach is required for estimating time‐varying default probabilities and recovery rates that are conditional on default. This paper develops and applies such a model.     

Taxes,Default Risk,and Yield Spreads

This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax-free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break-even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds.