A Markov model for the term structure of credit risk spreads

This article provides a Markov model for the term structureof credit risk spreads. The model is based on Jarrow and Turnbull(1995), with the bankruptcy process following a discrete statespace Markov chain in credit ratings. The parameters of thisprocess are easily estimated using observable data. This modelis useful for pricing and hedging corporate debt with imbeddedoptions, for pricing and hedging OTC derivatives with counterpartyrisk, for pricing and hedging (foreign) government bonds subjectto default risk (e.g., municipal bonds), for pricing and hedgingcredit derivatives, and for risk management.     

Systematic risk,debt maturity,and the term structure of credit spreads

We document several facts about corporate debt maturity: (1) debt maturity is pro-cyclical, (2) higher-beta firms tend to have longer maturity, and (3) shorter maturity amplifies the sensitivity of credit spreads to aggregate shocks. We present a dynamic capital structure model that explains these facts. In the model, leverage and maturity choices are interdependent, which reflect the tradeoffs of liquidity discounts of long-term debt, repayment risks of short-term debt, and the benefit of short-term debt as a commitment device for timely leverage adjustments. Additionally, the model helps quantify the effects of maturity dynamics on the term structure of credit spreads.     

Understanding the term structure of credit default swap spreads

The shape of the term structure of credit default swap (CDS) spreads displays large variations over time and across firms. Consistent with the predictions of structural models of credit risk, we find that the slope of CDS spread term structure increases with firm leverage and volatility, but decreases with the level and the slope of the Treasury yield curve. However, these variables together have rather limited explanatory power for CDS slope and there is a significant common component in the regression residuals. In addition, we find that CDS slope predicts future changes in the CDS spreads, even after controlling for the contemporaneous variables that determine changes in the CDS spreads according to the structural models. Our results suggest that while structural models are qualitatively useful for understanding the shape of credit term structure, there are missing factors that importantly affect the term structure of CDS spreads.     

Implied liquidity risk premium in the term structure of sovereign credit default swap and bond spreads

In this study, we focus on the dynamic properties of the risk-neutral liquidity risk premium specific to the sovereign credit default swap (CDS) and bond markets. We show that liquidity risk has a non-trivial role and participates directly to the variation over time of the term structure of sovereign CDS and bond spreads for both the pre- and crisis periods. Secondly, our results indicate that the time-varying bond and CDS liquidity risk premium move in opposite directions which imply that when bond liquidity risk is high, CDS liquidity risk is low (and vice versa), which may in turn be consistent with the substitution effect between CDS and bond markets. Finally, our Granger causality analysis reveals that, although the magnitude of bond and CDS liquidity risk is substantially different, there is a strong liquidity flow between the CDS and the bond markets, however, no market seems to consistently lead the other.     

The joint estimation of term structures and credit spreads

We present a new framework for the joint estimation of the default-free government term structure and corporate credit spread curves. By using a data set of liquid, German mark denominated bonds, we show that this yields more realistic spreads than traditionally obtained spread curves that result from subtracting independently estimated government and corporate term structures. The obtained spread curves are smooth functions of time to maturity, as opposed to the twisting curves one gets from the traditional method, and are less sensitive to model specifications. To determine the ‘optimal’ model specification, we use a newly developed test statistic that compares spread curves from competing models.     

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.     

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.     

Predicting credit spreads

Predictions of firm-level credit spreads based on the current spot and forward credit spreads can be significantly improved upon by using the information contained in the shape of the credit-spread curve. However, the current credit-spread curve is not a sufficient statistic for predicting future out-of-sample credit spreads; predictions can be significantly improved upon by exploiting the information contained in the shape of the riskless yield curve. In the presence of credit-spread and riskless factors, other macroeconomic, marketwide, and firm-specific risk variables do not significantly improve predictions of credit spreads. These results have important implications for credit-spreads modeling as well as for better understanding corporate capital structure and risk management policies.     

An analysis of credit risk spreads for high yield bonds

The overall growth and volatility in the high yield (HY) bond market has provided a viable source of capital and an interesting investment asset class. The result has been strong interest in the HY bond credit risk spread (CRS) because this series is very volatile and has a significant impact on the availability of capital to issuers and the rates of return and risk results for investors. Given these trends in the HY bond market, our study has two purposes. The first is to examine statistical properties of the CRS series for the aggregate HY bond market and the three rated components. The second purpose is to interpret the influence that a set of variables are expected to have on future CRSs and, therefore, HY bond performance. In summary, the statistical analysis indicates a significant business cycle effect, but does not show a monetary policy impact. Additionally, the study finds significant differences in characteristics among bonds with alternative ratings. The analysis of specific variables highlights the strong influence of direct and indirect measures of default risk, capital market risk factors, a specific measure of monetary policy, and an impact from liquidity within the HY bond market. There was also evidence of segmentation within the HY bond market because the empirical results indicate that we should consider separate models across rating classes that employed different variables as well as coefficients that were significantly different for the same variables.     

The effect of corporate diversification on credit risk: new evidence from European credit default swap spreads

This article investigates the impact of corporate diversification on credit risk. To our best knowledge, this is the first paper to use credit default swap (CDS) spreads instead of bond yield or revalued book values to test the risk‐reduction hypothesis. The analysis relies upon a sample of STOXX^® EUROPE 600 index members and covers the years 2010–2014. After controlling for various CDS‐ and firm‐specific variables, we find that diversification strategies do not significantly lower CDS premiums. Multilevel mediation analysis further shows that information asymmetries overcompensate the risk‐reducing effects resulting from corporate diversification.     

The impact of credit rating announcements on credit default swap spreads

We document the ability of the credit default swap (CDS) market to anticipate favorable as well as unfavorable credit rating change (RC) announcements based on more extensive samples of credit rating events and CDS spreads than previous studies. We obtain four new results. In contrast to prior published studies, we find that corporate RC upgrades do have a significant impact on CDS spreads even though they are still not as well anticipated as downgrades. Second, CreditWatch (CW) and Outlook (OL) announcements, after controlling for prior credit rating events, lead to significant CARs at the time positive CW and OL credit rating events are announced. Third, we extend prior results by showing that changes in CDS spreads for non-investment-grade credits contain information useful for estimating the probability of negative credit rating events. Fourth, we find that the CDS spread impact of upgrades but not downgrades is magnified during recessions and that upgrades and downgrades also differ as to the impact of simultaneous CW/OL announcements, investment-grade/speculative-grade crossovers, current credit rating, market volatility, and industry effects.     

Economic links and credit spreads

Counterparty risk is an important determinant of corporate credit spreads. However, there are only a few techniques available to isolate it from other factors. In this paper we describe a model of financial networks that is suitable for the construction of proxies for counterparty risk. Using data on North American supplier–customer network of public companies, we find that, for each supplier, counterparties’ leverage and option implied volatilities are significant determinants of corporate credit spreads in the period after the 2008–2009 U.S. recession. Our findings are robust after controlling for several idiosyncratic, industry, and market factors.     

The term structure of interbank risk

We infer a term structure of interbank risk from spreads between rates on interest rate swaps indexed to the London Interbank Offered Rate (LIBOR) and overnight indexed swaps. We develop a tractable model of interbank risk to decompose the term structure into default and non-default (liquidity) components. From August 2007 to January 2011, the fraction of total interbank risk due to default risk, on average, increases with maturity. At short maturities, the non-default component is important in the first half of the sample period and is correlated with measures of funding and market liquidity. The model also provides a framework for pricing, hedging, and risk management of interest rate swaps in the presence of significant basis risk.     

Seeking causality between liquidity risk and credit risk: TED-OIS spreads and CDS indexes

Since the Global Financial Crisis, credit risk and its management have become one of the most appealing topics in finance literature. In this study, we investigate the interaction of credit risk and liquidity risk through the TED and the OIS spreads and various credit default swap indexes from the CDX and the iTraxx family (CDXIG, CDXHY, ITEEU, and ITEXO). The empirical analysis is conducted through the Kapetanios unit root test, the EGARCH model, the Bootstrap Toda-Yamamoto modified Wald test and the asymmetric causality analysis. The results of symmetric and asymmetric causality methods reveal that liquidity risk appears to play an important role in credit risk, and in most cases, the TED and the OIS spreads dominate the CDS indexes. It can, thus, be concluded that the TED and the OIS spreads are superior to the CDS indexes as an early warning indicator in the credit market.     

Leveraged buyouts and bond credit spreads

Recent decades have witnessed several waves of buyout activity. We find leveraged buyouts (LBOs) to be a significant concern for bondholders by showing that a) intra-industry credit spreads increase upon an LBO announcement, b) yields on bonds without event risk covenants are, on average, 21 basis points higher than those on same-firm bonds with such covenants, and c) structural models calibrated to historical LBO events imply an impact of 18–21 basis points on 10-year credit spreads. The impact is strongest in expansion periods and for bonds with maturities of 10–20 years.     

Individual stock-option prices and credit spreads

This paper introduces measures of volatility and jump risk that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain useful information for credit spreads and improve on historical volatilities when explaining the cross-sectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and (to a lesser extent) the implied-volatility skew matter for credit spreads. Detailed principal component analysis shows that a large part of the time-series variation in credit spreads can be explained in this way.     

Sarbanes-Oxley Act and corporate credit spreads

Stock market reaction suggests that despite improved disclosure and increased accountability, Sarbanes-Oxley Act (SOX) is too costly and not beneficial. Noting that bondholders are likely to reap the many potential benefits of SOX without bearing the brunt of costs, we examine how SOX affected corporate credit spreads to better assess its benefits. SOX has led to a significant structural decline in spreads of at least 27 basis points. Riskier firms (low rating, long maturity, high leverage, and small size) and firms closely related to SOX major provisions (earning variability, managerial trading, and corporate governance) experience greater declines in spreads.     

The reaction of emerging market credit default swap spreads to sovereign credit rating changes

This paper examines the effect of sovereign credit rating change announcements on the CDS spreads of the event countries, and their spillover effects on other emerging economies’ CDS premiums. We find that positive events have a greater impact on CDS markets in the two-day period surrounding the event, and are more likely to spill over to other emerging countries. Alternatively, CDS markets anticipate negative events, and previous changes in CDS premiums can be used to estimate the probability of a negative credit event. The transmission mechanisms for positive events are the common creditor and competition in trade markets.