No full-text available
To read the full-text of this research,
you can request a copy directly from the authors.
The Determinants of Credit Spread Changes
Abstract
Using dealer’s quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross-correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply/demand shocks that are independent of both credit-risk factors and standard proxies for liquidity.
... The research of Collin-Dufresn et al. (2021) emphasizes that market risk will increase the credit spread of corporate bonds [49]. It was pointed out the importance of measuring market risk in credit spread models and concluded that companies operating in highmarket-risk environments would face a higher risk [50]. ...
... The study shows that when market risk increases, the yield spread of bonds also increases (0.36 bps), consistent with hypothesis 5a proposed, and this result is consistent with the study of the increase in volatility of S&P 500 futures contracts increases the yield spread [49]. A limitation of this study is the sample size of 688 bonds from Lehman Brothers through the Warga database, and the change in yield spread is explained very little by the independent variables along with contract volatility, suggesting that the volatility of S&P 500 futures contracts does not accurately represent market risk and has a low impact on bond yield spreads. ...
... When market risk increases, investors will also require a higher yield to compensate for the increased credit risk of the bond. The results are consistent with the studies [23,49]. The previous results conclude that increased market risk increases the credit spread of the issuer, meaning the bond risk issued by the company increases. ...
Green bonds are a relatively new financial product that offers investors a variety of alternatives. However, many individuals continue to be suspicious about its long-term returns and risks. To clarify this issue, this study employed two global environment events—COP26 and COP27—to influence investor attention and investor yield of green bonds and conventional bonds. The data are collected from 15,188 bonds, including 779 green bonds and 14,409 conventional bonds issued from 2021 to 2023 worldwide. The event study method has been conducted with pre- and post-event data to estimate the impact of green bond issuance before and after COP26 and COP27 on investor returns, as well as the impact of investor attention on investment returns. The research results show that investors should buy shares of companies that issue green bonds after major environmental events to benefit from the higher CAR of these companies. Investors can also use the S&P 1200 index as a measure to assess risk and abnormal returns when making short-term investments in shares of organizations that issue green bonds.
... Tang and Yan (2010) found that credit spreads tend to narrow with increases in GDP growth and the Consumer Confidence Index (CCI) based on their empirical analysis [9]. Additionally, Collin (2001) conducted a comprehensive study incorporating a range of macro-level factors in a regression model to analyze both positive and negative influences on credit spreads [3]. ...
... Despite extensive research, significant uncertainties remain regarding the determinants of credit spread changes. One notable limitation is that existing factors and regression models explain only about a quarter of the observed variations [3]. Furthermore, much of the analysis regarding these determinants is confined to qualitative insights, leaving a gap in quantitative prediction capabilities. ...
... Gertler (1991) identified GNP as a factor influencing credit spread changes [6]. A study by Collin (2001) summarized several financial market indicators that impact credit spreads, including the change in yield on 10-year Treasury bonds, the change in the 10-year minus 2-year Treasury yield spread, the change in implied volatility of the S&P 500, and the return on the S&P 500 [3]. Christiansen (2002) analyzed the relationship between macroeconomic indices, such as the Producer Price Index (PPI), and changes in credit spreads [2]. ...
The credit spread is a key indicator in bond investments, offering valuable insights for fixed-income investors to devise effective trading strategies. This study proposes a novel credit spread forecasting model leveraging ensemble learning techniques. To enhance predictive accuracy, a feature selection method based on mutual information is incorporated. Empirical results demonstrate that the proposed methodology delivers superior accuracy in credit spread predictions. Additionally, we present a forecast of future credit spread trends using current data, providing actionable insights for investment decision-making.
... Black and Scholes (1973), Merton (1974), Black and Cox (1976), among others. 3 Elton et al. (2001), Collin-Dufresne et al. (2001, Delianedis and Geske (2001), Huang & Huang (2003), Tsuji (2005), among others. 4 Chance (1990), Leland and Toft (1996), Duffie (1999), Longstaff et al. (2005), Ericsson and Renault (2006), Couderc et al. (2007), Liu et al. (2009). ...
... Elton et al. (2001), a pioneer empirical work in disentangling the determinants of corporate yield spread show that expected default loss (risk of default proxy) does not contribute to overall yield spread more than 25 percent. Among many others, Jones et al. (1984), Collin-Dufresne et al. (2001), Delianedis and Geske (2001), Huang and Huang (2003), Tsuji (2005), Liu et al. (2009), also show that, in general, risk of default does not contribute majorly in explaining overall yield spread as compared to other non-default factors. ...
... In order to evaluate the true effect of change in default risk proxy factors on change in yield spread, we control for different proxy variables reflecting the US macroeconomic and financial market condition. Following Tsuji (2005), as volatility in economic activity leads to affect investors' overall perception of required risk premium, we use change in Industrial Production Index rate (∆IPI) 7 as a control proxy for change in business cycle (Collin-Dufresne et al 2001). Furthermore, to control for the effects of inflation level, we use change in Consumer Price Index (∆CPI). ...
According to theoretical models of valuing risky corporate securities, risk of default is primary component in overall yield spread. However, sizable empirical literature considers it otherwise by giving more importance to non-default risk factors. Current study empirically attempts to provide relative solution to this conundrum by presuming that problem lies in the subjective empirical treatment of default risk. By using post-hoc estimator approach of Lubotsky & Wittenberg (2006), we construct an efficient indicator for risk of default, by using sample of 252 US non-financial corporate data (2000-2010). On average, our results validate that almost 48% of change in yield spread is explained by default risk especially in recent financial crisis period (2007-2009). Hence, our results relatively suggest that potential problem lies in the ad-hoc measurement methods used in existing empirical literature.
... The existing literature demonstrates that credit spreads are influenced by multiple factors, which reflect their multidimensional nature. While Merton (1974) developed a theoretical framework for firm-level default risk, Collin-Dufresne et al. (2001) provided empirical evidence of credit spread determinants. Subsequently, many empirical studies have deliberated on credit spread drivers. ...
... The increased uncertainty affects the pricing of financial instruments, including corporate bonds. As market volatility rises (including stocks, exchanges, and government bonds), investors become more risk averse and demand higher compensation for taking on the additional risks associated with holding corporate bonds (Carr and Wu, 2007;Collin-dufresne et al., 2001;John and Taksler, 2003). ...
Purpose
While the existing literature lacks a holistic approach to determining credit spreads and is limited to mostly developed countries, this study investigates credit spread determinants and their cross-country connectedness in the context of four emerging economies in Asia by incorporating bonds, market risk, macroeconomic and global factors.
Design/methodology/approach
This study utilizes principal component analysis for dimensionality reduction and variable representation. Furthermore, we employ the dynamic conditional correlation–generalized autoregressive conditional heteroskedasticity model to capture the cross-country credit spread connectedness between the variables.
Findings
The findings indicate that market volatilities are the most significant drivers of credit spreads, while global factors play a moderating role. Furthermore, the results provide compelling evidence of cross-country credit spread connectedness, with China as the primary transmitter and Malaysia as the primary receiver among the selected emerging economies.
Originality/value
This study addresses the limitations of previous research by extending the analysis beyond the commonly studied developed economies and focusing on emerging economies in Asia. It also employs a comprehensive approach to determine credit spread and explores cross-country credit spread connectedness in developing economies, thereby shedding light on financial risks and vulnerabilities within interconnected global financial systems.
... While Merton (1974) developed a theoretical framework for firm level default risk, Collin (2001) provided empirical evidence about determinants of credit spread. Subsequently, numerous empirical studies have noted that credit spread determinants are multidimensional, and several factors are responsible for the changes in credit spread. ...
... Similarly, the stock market volatility was significant and positively associated with credit spreads across the maturity spectrum. Market volatility emulates the idiosyncratic volatility and both are assumed to be highly correlated with each other (Collin-Dufresne et al., 2001). This evidence also supports (John Y. Campbell and Glen B. Taksler 2003) argument that idiosyncratic volatility drives the bond spreads significantly. ...
We present a comprehensive analysis of the credit spread determinants in five Asian bond markets over a sample period of 10 years, from January 2010 to December 2019. Consistent with the western literature, we find that the structural models are broadly valid even in emerging countries with developing bond markets. Empirical results unveiled that bond-specific liquidity is the most important driver that reduces the credit spread, followed by the slope of the term structure and industrial growth in the economy. In Emerging Asia, inflation is the key driver that aggravates credit spread for business firms, followed by financial market volatility. Cross-country data reveals that the Chinese corporate bond market is the largest in Asia. Indian markets offer higher yield rates, while credit spread is noted to be highest in China. The empirical findings of our study would provide important insights for the policy makers while developing the most sought-after liquid bond markets. Effective liquid bond markets would reduce the cost of capital for firms and price credit risks efficiently.
... Nevertheless, empirical studies present mixed evidence. Ericsson et al. (2009) confirm that the theoretical determinants of default risk are statistically and economically significant; conversely, Collin-Dufresn et al. (2001) argue that variables that should, in theory, determine changes in credit spread have limited explanatory power. Other explanatory variables proposed in the literature include total and idiosyncratic firm-specific volatility (Campbell and Taksler, 2003), option-implied volatility (Cao et al., 2010), equity volatility and jump risk measures (Zhang et al., 2009), firm fundamentals (Bai and Wu, 2016), Merton distance-to-default measure (Bharath and Shumway, 2008), liquidity risk (Bongaerts et al., 2011), negative capital shocks (Siriwardane, 2019), and firmspecific ambiguity (Augustin and Izhakian, 2020). ...
... For macroeconomic controls, we use the 10-year constant maturity Treasury yield (r10) as a proxy for the risk-free rate and the returns of the S&P500 (SP 500) as a proxy for the general business climate (Collin-Dufresn et al., 2001;Ericsson et al., 2009). We also control for the slope of the term structure of risk-free rates (T SSlope), the volatility index (V IX), and macroeconomic ambiguity (Ambiguity SP 500). ...
... Nevertheless, Jermias and Yigit (2019) reported the opposite results. Notably, a higher ratio of debt financing increases the PD and decreases the distance-to-default (Dwyer et al., 2004;Collin-Dufresne et al., 2001;Vassalou & Xing, 2004;Traczynski, 2017), especially when the debt ratio exceeds a certain buffer (Eldomiaty et al., 2016). Chandrapala and Knápková (2013) and Kavussanos and Tsouknidis (2016) conclude that companies with a higher debt ratio might experience increased financial distress. ...
Efficient management of bankruptcy risk requires treating distant-to-default (DD) stochastically as long as historical stock prices move randomly and, thus, do not guarantee that history may repeat itself. Using long-term data that date back to 1952–2023, including the nonfinancial companies listed in the Dow Jones Industrial Average and National Association of Securities Dealers Automated Quotations indexes, this study estimates the historical and stochastic DDs via the geometric Brownian motion (GBM). The results show that (a) the association between the debt-to-equity ratio and the stochastic DD can be used as an indicator of excessive debt financing; (b) debt tax savings have a positive effect on stochastic DD; (c) bankruptcy costs have negative effects on stochastic DD; (d) in terms of the size of the company being proxied by sales revenue and the equity market value of the company, the DD is a reliable measure of bankruptcy costs; (e) in terms of macroeconomic influences, increases in the percentage change in manufacturing output are associated with lower observed and stochastic DD; and (f) in terms of the influences of industry, the stochastic DD is affected by the industry average retail inventory to sales. This paper contributes to related studies in terms of focusing on the indicators that a company’s management can focus on to address the stochastic patterns inherent in the estimation of the DD.
... While the negative relation between the spreads and these two factors are more pronounced for firms with higher default probabilities i.e. lower grade bonds, the investment grade bonds are more susceptible to changes in the interest rates rather than changes in the value of the assets of the firm. Though based on different kind of methods, subsequent studies appeared to support this finding that includesAvramov et al., (2007), Ahmad, Muhammad andMasron (2009), Batten, Fetherston andHoontrakul (2006), Boss and Scheicher (2002), Demchuk and Gibson (2003), Collin-Dufresne, Goldstein and Martin (2001), Giesecke et al., (2011), Rahman (2003, Rahman (2008) and Yap and Gannon (2007). ...
This study explores the influencing factors of the Islamic bond (sukuk) spreads, by employing the generalised autoregressive conditional heteroscedasticity (GARCH) method. Apart from the general GARCH (1,1) model, a higher order of lags for both ARCH and GARCH terms are also considered which is applied onto both the investment and non-investment grade sukuk. This study is among the first few to document the empirical evidence on sukuk spreads and its volatility which is expected to further enrich the empirical literature of the financial markets especially in the Islamic finance. This is in line with the pressing demand for more in-depth information on various dimensions of the sukuk market given the importance of the sukuk in the global capital market. This study contributes significantly to the benefit of the investors, portfolio managers as well as regulators to better understand the underlying factors influencing the pricing and risk management of sukuk instruments. In addition, the assessment on the impact of therecent global financial crisis allows for a thorough understanding on the behavior of sukuk spreads so as to pre-empt the impact of future financial shocks to the sukuk market.
... The literature has documented a yield spread puzzle in that standard term structure variables cannot explain temporal variations in yield spreads (see, for example, Collin-Dufresn et al. 2001;Elton et al. 2001;Driessen 2005;Houweling et al. 2005). To see if policy uncertainty plays a role in this puzzle, we decompose offering yield spreads into two components suggested by Gilchrist and Zakrajšek (2012): default probability (DP), which captures expected default losses, and the excess bond risk premium (RP). ...
This paper investigates the effect of policy uncertainty on offering yield spreads using a comprehensive corporate bond issuing dataset. Empirical evidence shows a significant positive impact of policy uncertainty on offering yield spreads of bonds. This effect is more substantial for firms with higher exposure to tax policy, greater dependence on external finance, a less transparent information environment, and a weaker economy. Bond covenants moderate the uncertainty effect as covenants provide a trigger for renegotiation. Further analysis shows that the policy uncertainty premium in the bond market drives the negative impact of policy uncertainty on corporate investments.
... However, the Merton model does not fully address the credit spread puzzle -the gap between corporate bond yields and risk-free securities. Scholars like Chen, Collin-Dufresne, andGoldstein (2009) andMartin (2001) suggest incorporating market factors to improve explanatory power. Wisniewski and Lambe (2015) further examine the effect of economic uncertainties. ...
This study examines the policy determinants of bank default risk, proxied by credit default swap (CDS) spreads, using quarterly data from the U.S. and Canada for the period 2020 to 2022. The analysis considers four determinant groups: the COVID-19 pandemic shock, aggressive monetary and fiscal policy responses, macroprudential-related bank financial fundamentals, and macroeconomic and market conditions. Utilizing General Least Squares (GLS) and dynamic panel models with system General Method of Moments (GMM), the findings reveal that rising COVID-19 deaths significantly widen CDS spreads. Expansionary monetary policies reduce bank default risk, though the effectiveness under conventional monetary policy is reduced by increasing COVID-19 deaths. In contrast, expansionary fiscal policies and inflation broaden CDS spreads. The combined analysis highlights policy stances as dominant factors, with macroprudential-related fundamentals having minimal impact. The findings are robust using both 5-year and 10-year CDS measures. This study has significant policy implications during health and economic crises. For financial stability, policymakers should prioritize reducing pandemic-related deaths, utilize expansionary monetary policies with health support strategies, balance fiscal support to avoid excessive government spending, and implement measures to control inflation. It is essential to enhance coordination between healthcare, fiscal, and monetary authorities for effective policy implementation.
... Krishnan et al. (2005) argue that credit spreads didn't provide useful signaling for bank market discipline, and changes in credit spreads didn't reflect the changes in default risks between 1994 and 1999, although the levels of credit spreads reflect the risks of individual institutions. Collin-Dufresne et al. (2001) and Krishnan et al. (2005) find that the traditional measures of default risks are not enough to explain the changes in nonfinancial corporate credit spreads. Driessen (2005) finds that the company specific default risk premium are small in the levels of credit spreads of solvent companies. ...
This study examines the too-big-to-fail expectations in the primary market issuance spreads of commercial bank tier-2 capital bonds and additional tier-1 capital bonds in China. Using a sample of 574 issuances with total amount of 4.76 trillion RMB (749 billion USD), we conduct median regressions with the issuance spreads as the dependent variable. The coefficients of DSIB and GSIB are negative and statistically significant at 1% and 5% levels respectively in the full sample, and are negative and statistically significant at 1% level in the subsample after the guidance on asset management businesses was announced. Ceteris paribus, the issuance spreads of capital bonds of systemically important banks are 15.2 bps to 19.7 bps lower than those issued by other banks. The too-big-to-fail expectations and implicit guarantee of systemically important banks in the Chinese bond market, which narrow the primary market spreads of capital bonds issued by systemically important banks, may account for the results. To address the potential endogeneity issues, we use 90% quantile and 95% quantile of sample bank consolidated assets as proxies of systemic importance, and use China Development Bank bond yields to calculate issuance spreads, and the results show that the conclusion is robust.
... 3 Secondary market measures rely on the substantial academic literature on pricing and measures of secondary market liquidity in the corporate bond market (e.g., Collin-Dufresne et al., 2001, Geske and Delianedis, 2001, Longstaff et al., 2005, Chen et al., 2007, Dick-Nielsen et al., 2012, Friewald et al., 2012, Helwege et al., 2014, Chen et al., 2017, and Friewald and Nagler, 2019). ...
We examine the ability of structural models to predict credit spreads using global default data and security‐level credit spread data in eight developed economies. We find that two representative, pure default‐risk models tend to underpredict the average credit spreads on investment‐grade (IG) bonds, especially their spreads over government bonds, thereby providing evidence for a “global credit spread puzzle.” However, a model incorporating endogenous liquidity in the secondary debt market helps mitigate the puzzle. Furthermore, the model captures certain determinants of corporate bond market frictions across the eight economies and substantially improves the cross‐sectional fit of individual IG credit spreads.
Purpose
We examine yield spreads, defined as the difference between the yield to maturity of the risky bank bond and that of a risk-free bond with similar maturity and other characteristics, after controlling for market, liquidity and tax factors. We use senior bonds issued by banks since one of the goals of the Dodd–Frank Act (DFA) is to reduce the possibility of a full-fledged bailout of banks. If markets do not believe that banks will be bailed out, senior bondholders will bear a higher exposure to default risks, and such risk perceptions will be reflected in the yield spread levels.
Design/methodology/approach
We use generalized method of moments (GMM) for parameter estimation with standard errors corrected for autocorrelation and heteroskedasticity using the Newey–West (1987) procedure with five lags.
Findings
Our results indicate a discount of 133 basis points in yield spreads due to the TBTF or too-big-to-fail factor prior to the DFA. However, the market charges a net premium of 36 basis points for the TBTF factor immediately after the DFA (a total change of 169 basis points). We examine commercial banks and noncommercial banks (primarily investment banks and insurance firms) separately. For commercial banks, the discounts observed prior to the DFA changes to a premium after the DFA. For investment banks, the higher premium charged prior to the DFA is reduced after the DFA.
Research limitations/implications
Not all banks issue bonds and not all issued bonds trade in the secondary market frequently.
Practical implications
After the Great Recession, there is a sustained effort across the globe, to remove the possibility of a bailout of very large banks. With systemic risk monitoring, improved capital regulation, stress testing and other regulations on banks and other shadow banking organizations, the question of whether market perceives implicit guarantee of very large financial institutions. We have examined a new security that is not treated as capital.
Social implications
If taxpayer bailouts are avoided, such resources can be used for other developmental purposes. The moral hazard problems of bank manager are also reduced.
Originality/value
We are the first to exclusively examine the senior bonds issued by banks around the enactment of the DFA, 2010.
In this article, we examine the effects of Title II of the Jumpstart Our Business Startups (JOBS) Act on the cost and issue size of Rule 144 debts for a sample from 2002 to 2019. We find that after the enactment of the JOBS Act, the average cost (issue size) of the Rule 144 A offers decreases (increases) significantly. The findings are robust after controlling for issue‐, issuer‐, and country‐specific characteristics as well as market conditions. Evidence based on the propensity‐score‐matched sample, including public debt issues, subsample analyses, difference‐in‐differences tests, and alternative event windows, further shows that domestic firms benefit more from the JOBS Act as they have a greater reduction in the cost of debt and increase in the issue size. Overall, our results are consistent with the increased investor base hypothesis and suggest that Title II of the JOBS Act satisfies Congress's goal of making it more cost efficient for Rule 144 A issuers.
This study delves into whether factors influencing credit spreads differ between sukuk and bonds within the vibrant Indonesian secondary market. The research leverages unbalanced panel data encompassing 2017-2023, meticulously obtained from Thomson Reuters Eikon and CEIC. To extract meaningful insights, a Fixed-Effect Model analysis is employed, a robust technique for handling this type of data. The study further conducts a partial analysis to recognize the potential heterogeneity within the sukuk market. This analysis explores explicitly whether the factors driving yield spread exhibit variations between sukuk structured under the ijarah and mudharabah principles. The study's core finding challenges the notion that investors perceive sukuk as a perfect substitute for conventional bonds in terms of the risk-return profile. This is evidenced by the high degree of similarity in the factors that influence the credit spreads of both instruments. However, a fascinating discovery emerges from the partial analysis. It reveals that mudharabah sukuk stands out as a distinct product within the Indonesian secondary debt market compared to its ijarah counterpart. This finding warrants further investigation into the specific characteristics of mudarabah sukuk that contribute to its distinctiveness.
Using several approaches to compute firms’ credit risk correlation, we provide robust empirical evidence that lenders charge higher loan spreads to borrowers with higher credit risk correlation. Consistent with the theoretical literature, we find that the credit risk correlation effect is concentrated in investment‐grade firms, driven by tightening lending conditions, and more pronounced for firms with higher rollover risk. We also show that banks whose borrowers have higher average credit risk correlation, have greater default risk themselves. Overall, our results indicate that banks view credit risk correlation as an important risk factor.
We provide a simple model of investment by a firm funded with debt and equity and empirical evidence to demonstrate that, once we control for the debt overhang problem with credit spreads, asset volatility is an unambiguously positive signal for investment, while equity volatility sends a mixed signal: Elevated volatility raises the option value of equity and increases investment for financially sound firms, but exacerbates debt overhang and decreases investment for firms close to default. Our study provides a simple unified understanding of the structural and empirical relationships between investment, credit spreads, equity versus asset volatility, leverage, and Tobin's .
This study explores various dimensions of the Indian capital market, encompassing the Indian corporate bond market. It's crucial to understand the determinants of corporate bond yield. Objective of the study is to examine the factors influencing corporate bond yield in the Indian bond market. The study adopted a time series analysis using a regression model. The yield curve's slope shows a negative correlation. Changes in the Treasury bill rate, the Index of Industrial Production, and currency rates influence positively to the corporate bond yield. The study did not find any relation with the changes in bank rates, industrial production growth, inflation, Nifty returns. The study adds significant understanding of the complicated relationships influencing corporate bond yield dynamics and has consequences for investors and financial experts.
This paper examines the impact of corporate social responsibility (CSR) expenditure on default risk for Indian firms during the period from 2015 to 2021. Using distance to default (DTD) and probability of default (PD) at different time horizons as proxies for default risk, we find that CSR expenditure is negatively related to default risk. This indicates that CSR engagement enhances a firm’s reputation and financial stability, thereby reducing the likelihood of default. Surprisingly, we find that this relationship is less pronounced for group-affiliated firms, as stand-alone firms rely more on CSR to establish market credibility. Our findings highlight the strategic importance of CSR compliance, emphasizing its role in risk management and financial resilience. Our study provides insights for policymakers and managers in emerging economies, underscoring how mandatory CSR can foster a more sustainable and risk-averse corporate environment, particularly for firms without the support of business group affiliation.
We decompose corporate bond and equity index returns into duration-matched government bond returns and the excess returns over this duration-matched counterfactual, which we term duration-adjusted returns. Compared with previously used excess return definitions (ie, returns in excess of Treasury bills), our decomposition leads to markedly different return patterns and asset pricing implications. In particular, we find that investment-grade bonds earn a small credit risk premium, comparable in magnitude to the convenience yield, and that duration adjustment resolves the CAPM’s failure to price corporate bonds. These findings highlight the importance of adjusting for nonstationary interest rate environments in asset pricing tests. (JEL G10, G12)
The corporate bond market is larger, more illiquid, and presumably less efficient than the equity market. These features provide numerous profit opportunities for corporate bond mutual funds that are unique to the corporate bond market. However, whether corporate bond mutual funds have the valuation skills needed to take advantage of these opportunities is unclear. We introduce a novel measure to assess the valuation skills of investment-grade corporate bond mutual funds, which we refer to as the valuation accuracy score (VAS). VAS recognizes funds holding more underpriced and less overpriced corporate bonds as ex-ante having better valuation skills. It predicts future fund performance, is stable over time, and is unrelated to other sources of skill. Investors chase the performance of higher-VAS funds more aggressively and exhibit a convex flow-performance relation among these funds.
The paper examines the determinants of sovereign CDS spreadsfor 19 different primary sovereigns from January 2009 to December2018, using several macroeconomic variables. We apply apanel vector autoregressive (PVAR) model using a system-generalizedmethod of moment (System-GMM) methodology, to analysethe relationship between the CDS spreads and its macroeconomicdeterminants. Our model combines both local factors, suchas GDP growth rate, import, export, inflation rate, the balanceof payment, and government external debt with global factorssuch as S&P 500 Index (SP500) returns, CBOE Market VolatilityIndex (VIX), and 10-year U.S. Treasury. We find that both local(such as inflation and government external debt), and global(e.g., VIX) determinants of sovereign CDS spreads are statisticallysignificant through various periods for most maturities.
Studying China's credit market using a structural default model that integrates credit risk, liquidity, and bailout, we document improved price discovery and a deepening divide between state‐owned enterprises (SOEs) and non‐SOEs. Amidst liquidity deterioration, the presence of government bailout helps alleviate the heightened liquidity‐driven default, making SOE bonds more valuable and widening the SOE premium. Meanwhile, the increased importance of government support makes SOEs more sensitive to bailout, while the heightened default risk increases non‐SOEs' sensitivity to credit quality. Examining the real impact, we find severe performance deteriorations of non‐SOEs relative to SOEs, reversing the long‐standing trend of non‐SOEs outperforming SOEs.
We estimate the term structure of corporate bond liquidity premiums using a dual estimation technique. Our estimates reveal that the term structures of the liquidity premiums were positively sloped and concave for each category of creditworthiness and in three economic epochs. As the macroeconomy transitioned from a pre-crisis to a crisis period, liquidity premiums elevated across time to maturity for both investment grade and speculative grade bonds. With the migration of the financial system from stress to relative calm, the premiums on both grades of debt declined for all maturities.
Firms with high leverage experience a more pronounced increase in credit spreads than firms with low leverage in response to a monetary policy tightening. A large fraction of this increase is due to a component of credit spreads that is in excess of firms’ expected default risk. A stylized heterogeneous firm model with default risk, financially constrained intermediaries, and segmented financial markets is able to account for these facts. Our findings imply that financial intermediaries play an important role in shaping the transmission of monetary policy to firm-level outcomes. (JEL D22, E43, E44, E52, G32)
This paper develops a corporate bond valuation model that takes into account both early default and interest rate risk. It corrects a defect of recent contributions where pricing equations do not assure that the payment to bondholders upon bankruptcy is no greater than firm value. The bankruptcy-triggering mechanism is directly related to the payoff received by bondholders when early bankruptcy is forced upon the firm. More specifically, the default barrier is defined simply as a fixed quantity discounted at the riskless rate up to the maturity date of the risky corporate bond. As soon as this threshold is crossed, bondholders receive an exogenously specified fraction of the remaining assets. Deviations from the absolute priority rule also are captured. Because it accounts for Gaussian interest rate uncertainty, default risk, and deviations from the absolute priority rule, this model is capable of producing quite diverse shapes for the term structure of yield spreads.
Several predetermined variables that reflect levels of bond and stock prices appear to predict returns on common stocks of firms of various sizes, long-term bonds of various default risks, and default-free bonds of various maturities. The returns on small-firm stocks and low-grade bonds are more highly correlated in January than in the rest of the year with previous levels of asset prices, especially prices of small-firm stocks. Seasonality is found in several conditional risk measures, but such seasonality is unlikely to explain, and in some cases is opposite to, the seasonal found in mean returns.
A model of dynamic capital structure is proposed. Even though the optimal strategy is implemented over an arbitrarily large number of restructuring-periods, a scaling feature inherent in the framework permits simple closed-form expressions to be obtained for equity and debt prices. When a firm has the option to increase future debt levels, tax advantages to debt increase significantly, and both the optimal leverage ratio range and predicted credit spreads are more in line with what is observed in practice. Copyright 2001 by University of Chicago Press.
This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing
on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of
a credit-spread option.
When a firm is close to bankrupcy, equity-holders may `blackmail' owners of bonds by paying less than the originally-contracted coupon payments. This paper develops simple, closed-form expressions for bond and equity values when such blackmail effects are present. Furthermore, we show that blackmail is optimal in the following sense. Without blackmail, leverage generates agency costs because value-maximizing equity-holders liquidate firms at output price levels other than the ex-ante optimum. However, if equity-holders can extract surplus from bond-holders through blackmail, they will actually choose to liquidate the firm at the ex ante optimal shut-down point.
When firms experience financial distress, equity holders may act strategically, forcing concessions from debtholders and paying less than the originally contracted interest payments. This article incorporates strategic debt service in a standard, continuous time asset pricing model, developing simple closed-form expressions for debt and equity values. The authors find that strategic debt service can account for a substantial proportion of the premium on risky corporate debt. They analyze the efficiency implications of strategic debt service, showing that it can eliminate both direct bankruptcy costs and agency costs of debt. Copyright 1997 by American Finance Association.
Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cash flow/price, book-to-market equity, past sales growth, long-term past return, and short-term past return. Because these patterns in average returns apparently are not explained by the CAPM, they are called anomalies. We find that, except for the continuation of short-term returns, the anomalies largely disappear in a three-factor model. Our results are consistent with rational ICAPM or APT asset pricing, but we also consider irrational pricing and data problems as possible explanations.
This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a ''spot exchange rate.'' Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps.
This paper examines the risks and returns of long‐term low‐grade bonds for the period 1977–1989. We find: (1) low‐grade bonds realized higher returns than higher‐grade bonds and lower returns than common stocks, and low‐grade bonds exhibited less volatility than higher‐grade bonds due to their call features and high coupons; (2) there is no relation between the age of low‐grade bonds and their realized returns; cyclical factors explain much of the observed relation between default rates and bond age; and (3) low‐grade bonds behave like both bonds and stocks. Despite this complexity there is no evidence that low‐grade bonds are systematically over‐ or under‐priced.
I examine institutional bond trading costs and practices using a data set of 192,000 trades of corporate bonds over 1993-1995. I find that institutional bond trades are typically much larger than institutional equity trades, but trading costs are a much smaller proportion of the trade's value. Trading costs decline with the size of the trade. Larger, more active institutions pay less to trade even after adjusting for the size of their trades. Institutions seem to develop relationships with particular dealers, as evidenced by a disproportionate number of trades between the institution and the dealer. However, trading costs are not lower when an institution has established a relationship with a dealer.
This article provides a Markov model for the term structure of credit risk spreads. The model is based on Jarrow and Turnbull (1995), with the bankruptcy process following a discrete state space Markov chain in credit ratings. The parameters of this process
are easily estimated using observable data. This model is useful for pricing and hedging corporate debt with imbedded options,
for pricing and hedging OTC derivatives with counterparty risk, for pricing and hedging (foreign) government bonds subject
to default risk (e.g., municipal bonds), for pricing and hedging credit derivatives, and for risk management.
This study documents, for the first time, the severity of bond defaults stratified by Standard Industrial Classification sector and by debt seniority. The highest average recoveries came from public utilities (70 percent) and chemical, petroleum, and related products (63 percent). The differences between those sectors and all the rest are statistically significant, even when adjusted for seniority. The original rating of a bond issue as investment grade or below investment grade has virtually no effect on recoveries once seniority is accounted for. In addition, neither the size of the issue nor the time to default from its original date of issuance has any association with the recovery rate. These results should provide important information for investors as well as analysts.
This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. These results imply a dynamic process for credit spreads that is not captured in existing models for pricing corporate bonds or measuring their interest rate sensitivity.
Expected returns on common stocks and long-term bonds contain a term or maturity premium that has a clear business-cycle pattern (low near peaks, high near troughs). Expected returns also contain a risk premium that is related to longer-term aspects of business conditions. The variation through time in this premium is stronger for low-grade bonds than for high-grade bonds and stronger for stocks than for bonds. The general message is that expected returns are lower when economic conditions are strong and higher when conditions are weak.
This paper examines the structure of option valuation problems and develops a new technique for their solution. It also introduces several jump and diffusion processes which have not been used in previous models. The technique is applied to these processes to find explicit option valuation formulas, and solutions to some previously unsolved problems involving the pricing of securities with payouts and potential bankruptcy.
This paper examines the correlation between the returns on individual stocks and the yield changes of individual bonds issued by the same firm, and finds that they are negatively and contemporaneously correlated. This suggests that individual stocks and bonds are driven by firm-specific information that is predominantly related to the mean, rather than the variance, of the firm's underlying assets. Furthermore, I find that lagged stock returns have explanatory power for current bond yield changes, while current stock returns are unrelated to lagged bond yield changes. This shows that stocks lead bonds in reflecting firm-specific information.
This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.
Multivariate density estimation (MDE) suggests that mortgage-backed security (MBS) prices can be well described as a function of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons. An important finding is that the interest rate level proxies for the moneyness of the option, the expected level of prepayments, and the average life of the cash flows, while the term structure slope controls for the average rate at which these cash flows should be discounted.
If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.
This article studies how collateral affects bond yields. Using a large data set of public bonds, we document that collateralized debt has higher yield than general debt, after controlling for credit rating. Our model of agency problems between managers and claim holders explains this puzzling result by recognizing imperfections in the rating process. We test the model's implications. Consistent with our model and in results new to the literature, we find the yield differential between secured and unsecured debt, after controlling for credit rating, is larger for low credit rating, nonmortgage assets, longer maturity, and with proxies for lower levels of monitoring.
This article studies the design and valuation of debt contracts in a general dynamic setting under uncertainty. We incorporate
some insights of the recent corporate finance literature into a valuation framework.
The basic framework is an extensive form game determined by the terms of a debt contract and applicable bankruptcy laws. Debtholders
and equityholders behave noncooperatively. The firm’s reorganization boundary is determined endogenously.
Strategic debt service results in significantly higher default premia at even small liquidation costs. Deviations from absolute
priority and forced liquidations occur along the equilibrium path. The design tends to stress higher coupons and sinking funds
when firms have a higher cash payout ratio.
Announcements of successful leveraged buyouts (LBOs) during January 1985 to April 1989 caused a significantly negative return
on outstanding publicly traded nonconvertible bonds. Yet the average risk-adjusted debt holder losses are less than 7 percent
of the average risk-adjusted equity holder gains. Bond losses are related to the pre-LBO rating, but only weakly to equity
holder gains. We demonstrate that trader-quoted data from a major investment bank offers conclusions about the effects of
LBOs on debt holders different from those drawn from commonly used matrix and exchange-based data (such as Standard & Poor’s
Bond Guide data). This has important implications for event studies involving debt instruments.
Using a unique dataset based on daily and hourly high-yield bond transaction prices, we find the informational efficiency of corporate bond prices is similar to that of the underlying stocks. We find that stocks do not lead bonds in reflecting firm-specific information. We further examine price behavior around earnings news and find that information is quickly incorporated into both bond and stock prices, even at short return horizons. Finally, we find that measures of market quality are no poorer for the bonds in our sample than for the underlying stocks. Copyright 2002, Oxford University Press.
It appears that volatility in equity markets is asymmetric: returns and conditional volatility are negatively correlated. We provide a unified framework to simultaneously investigate asymmetric volatility at the firm and the market level and to examine two potential explanations of the asymmetry: leverage effects and volatility feedback. Our empirical application uses the market portfolio and portfolios with different leverage constructed from Nikkei 225 stocks. We reject the pure leverage model of Christie (1982) and find support for a volatility feedback story. Volatility feedback at the firm level is enhanced by strong asymmetries in conditional covariances. Conditional betas do not show significant asymmetries. We document the risk premium implications of these findings. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
Multivariate density estimation (MDE) suggests that mortgage-backed security (MBS) prices can be well described as a function
of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons. An important
finding is that the interest rate level proxies for the moneyness of the option, the expected level of prepayments, and the
average life of the cash flows, while the term structure slope controls for the average rate at which these cash flows should
be discounted. Though the origination and prepayment behavior of mortgages differ substantially across coupons, there remains
an unexplained common factor in MBS prices. This factor does not seem to be related to the usual suspects and therefore presents
a puzzle to financial economists.
This paper examines the return characteristics of low-grade bonds using dealer bid prices. The volatility of an index of these bonds is less than the volatility of indexes of higher-grade bonds such as long-term Treasury bonds. This reduced volatility is due in large part to the shorter duration of low-grade bonds. We also present evidence that low-grade bonds are a hybrid security with features of both stocks and bonds. A detailed analysis of the returns realized by all low-grade bonds issued in 1977 and 1978 indicates that any relation between bond age and probability of default does not induce a bias in the results based on our index of lower-grade bonds. Moreover, we present evidence that at least part of the observed tendency for the probability of default to increase with age is due to cyclical factors.
The purpose of this article is to explain the spread between spot rates on corporate and government bonds. We find that the spread can be explained in terms of three elements: (1) compensation for expected default of corporate bonds (2) compensation for state taxes since holders of corporate bonds pay state taxes while holders of government bonds do not, and (3) compensation for the additional systematic risk in corporate bond returns relative to government bond returns. The systematic nature of corporate bond return is shown by relating that part of the spread which is not due to expected default or taxes to a set of variables which have been shown to effect risk premiums in stock markets Empirical estimates of the size of each of these three components are provided in the paper. We stress the tax effects because it has been ignored in all previous studies of corporate bonds.
We present an equilibrium production economy in which default occurs in equilibrium. The borrower chooses optimal default and consumption policies, taking into account that default is costly and the lender gains access to the technology upon default. We derive asset prices and default premia in this economy. The borrower's relative risk aversion in wealth increases with decreases in wealth due to the increased possibility of default at low wealth levels. This produces a time-varying pricing kernel and a countercyclical equity premium. We thus provide an equilibrium rationale for the default premium to influence expected asset returns.
The early work of Black and Scholes, and Merton, made the connection between conventional options and corporate liabilities. The standard textbooks now employ option-pricing arguments in discussing the valuation of stocks, bonds, convertible bonds and warrants; this discussion extends to the various features (such as call and sinking-fund features) that now are appended to these issues. The technique is to recognize that the value of a particular security derives from, or is contingent on, the value of the firm and other economic variables (such as the yield curve for government securities), and then apply the same valuation procedure that one would use to value a call option on some underlying common stock.
We examine the determinants of the realized bid-ask spread in the U.S. corporate, municipal and government bond markets for the years 1995 to 1997, based on newly available transactions data. Overall, we find that liquidity is an important determinant of the realized bid-ask spread in all three markets. Specifically, in all markets, the realized bid-ask spread decreases in the trading volume. Additionally, risk factors are important in the corporate and municipal markets. In these markets, the bid-ask spread increases in the remaining-time-to maturity of a bond. The corporate bond spread also increases in credit risk and the age of a bond. The municipal bond spread increases in the after-tax bond yield. Controlling for others factors, the municipal bond spread is higher than the government bond spread by about 9 cents per 100 par value, relative to the earlier years. Finally, the ten largest corporate bond dealers earn 15 cents per $100 par value higher than the remaining dealers, after controlling for differences in the characteristics of bonds traded by each group. We find no such differences for the government and municipal bond dealers.
We identify a class of term structure models possessing a generalized affine-structure that significantly extends the class studied by Duffie, Pan, and Singleton (2000). For this class of models, which includes both infinite-state-variable (ie HJM-type) and infinite-factor (random field) models, closed-form solutions for bond-option prices are obtained. Two special cases are investigated. First, a parsimonious model of `true' stochastic volatility is proposed, where innovations in derivative securities cannot be hedged by innovations in bond prices. Empirical support for this type of model is presented. Second, a two-factor arbitrage-free model of a long-rate, similar in spirit to that proposed by Brennan and Schwartz (1979, 1982), is introduced.
Because the option to call a corporate bond should rise in value when bond yields fall, the relation between noncallable Treasury yields and spreads of corporate bond yields over Treasury yields should depend on the callability of the corporate bond. I confirm this hypothesis for investment-grade corporate bonds. Although yield spreads on both callable and noncallable corporate bonds fall when Treasury yields rise, this relation is much stronger for callable bonds. This result has important implications for interpreting the behavior of yields on commonly used corporate bond indexes, which are composed primarily of callable bonds. Copyright The American Finance Association 1998.
This article develops a multi-factor econometric model of the term structure of interest-rate swap yields. The model accommodates the possibility of counterparty default, and any differences in the liquidities of the Treasury and Swap markets. By parameterizing a model of swap rates directly, the authors are able to compute model-based estimates of the defaultable zero-coupon bond rates implicit in the swap market without having to specify a priori the dependence of these rates on default hazard or recovery rates. The time series analysis of spreads between zero-coupon swap and treasury yields reveals that both credit and liquidity factors were important sources of variation in swap spreads over the past decade. Copyright 1997 by American Finance Association.
This paper examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's [1994] closed- form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency cost. The tax advantage of debt must be balanced against bankruptcy and agency cost in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga [1989]. The model has important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity".
We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed-form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model. Copyright 1995 by American Finance Association.
In this paper, I use institutional corporate bond trade data to estimate transactions costs in the over-the-counter bond market. I find average round-trip trading costs to be about 100 of par value. Trading costs are lower for larger trades. Small institutions pay more to trade than large institutions, all else being equal. Small bond dealers charge more than large ones. I find no evidence that trading costs more for lower-rated bonds. Copyright The American Finance Association 2001.
Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cash flow/price, book-to-market equity, past sales growth, long-term past return, and short-term past return. Because these patterns in average returns apparently are not explained by the capital asset pricing model, (CAPM), they are called anomalies. The authors find that, except for the continuation of short-term returns, the anomalies largely disappear in a three-factor model. Their results are consistent with rational intertemporal CAPM or arbitrage pricing theory asset pricing but the authors also consider irrational pricing and data problems as possible explanations. Copyright 1996 by American Finance Association.
This paper uses a vector autoregressive model to decompose excess stock and ten-year bond returns into changes in expectations of future stock dividends, inflation, short-term real interest rates, and excess stock and bond returns. In monthly postwa r U.S. data, stock and bond returns are driven largely by news about future excess stock returns and inflation, respectively. Real intere st rates have little impact on returns, although they do affect the short-term nominal interest rate and the slope of the term structure. These findings help to explain the low correlation between excess st ock and bond returns. Copyright 1993 by American Finance Association.
We study the implications of imperfect information for term structures of credit spreads on corporate bonds. We suppose that bond investors cannot observe the issuer's assets directly, and receive instead only periodic and imperfect accounting reports. For a setting in which the assets of the firm are a geometric Brownian motion until informed equityholders optimally liquidate, we derive the conditional distribution of the assets, given accounting data and survivorship. Contrary to the perfect-information case, there exists a default-arrival intensity process. That intensity is calculated in terms of the conditional distribution of assets. Credit yield spreads are characterized in terms of accounting information. Generalizations are provided.
This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. The authors apply the foreign currency analogy of R. Jarrow and S. Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a 'spot exchange rate.' Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps. Copyright 1995 by American Finance Association.
This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation. Copyright 1994 by American Finance Association.
This study extends the literature on the pricing of low-grade bonds by examining the performance of low-grade bond funds. The findings reveal that over the long run low-grade bond fund returns are approximately equal to the returns provided by an index of high-grade bonds. The relative risks of high and low-grade bonds are more difficult to assess. Because of their shorter durations, low-grade bonds are less sensitive to movements in interest rates than high-grade bonds. On the other hand, low-grade bonds are much more sensitive to changes in stock prices than high-grade bonds. When adjusted for risk using a simple two-factor model, the returns on low-grade bond funds are not statistically different from the returns on high-grade bonds. Copyright 1991 by American Finance Association.