The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors

This paper analyzes the components of corporate credit spreads. The analysis is based on a structural model that can offer a framework to understand the decomposition. The paper contends that default risk may correctly represent only a small portion of corporate credit spreads. This idea stems both from empirical evidence and from the following theoretical assumptions underlying contingent claim models of default: that markets for corporate stocks and bonds are (i) perfect, (ii) complete, and (iii) trading takes place continuously. Thus, in these models there are no transaction or bankruptcy costs, no tax effects, no liquidity effects, no jump effects reflecting market incompleteness, and no market risk factors effecting the pricing of corporate stocks or bonds. The paper starts with the use of a modified version of the Black-Scholes-Merton diffusion based option approach. We estimate corporate default spreads as simply a component of corporate credit spreads using data from November 1991 to December 1998, which includes the Asian Crisis in the Fall, 1998. First we measure the difference between the observed corporate credit spreads and option based estimates of default spreads. We define this difference as the residual spread. We show that for AAA (BBB) firms only a small percentage, 5% (22%), of the credit spread can be attributed to default risk. We show that recovery risk also cannot explain this residual spread. Next, we show that state taxes on corporate bonds also cannot explain the residual. We note that the pure diffusion assumption may lead to underestimates of the default risk. In order to include jumps to default, we next estimate what combined jump-diffusion parameters would be necessary to force default spread to eliminate the residual spread. In each rating class on average firms would be required to experience annual jumps that decrease firm value by 20% and increase stock volatility by more than 100% over their observed volatility in order to eliminate the residual spread. We consider this required increase in stock volatility to be unrealistic as the sole explanation of the residual spread. So next we consider whether the unexplained component can be partly attributable to interest rates, liquidity, and market risk factors. We find the following empirical results: i) increases in liquidity as measured by changes in each firm’s trading volume significantly reduces the residual spread, but does not alter the default spread; ii) increases in stock market volatility significantly reduces the residual spread by increasing the default spread relative to the credit spread, and iii) increases in stock market returns significantly increases the residual spread by reducing the default spread relative to the credit spread. This paper concludes that credit risk and credit spreads are not primarily explained by default and recovery risk, but are mainly attributable to taxes, jumps, liquidity, and market risk factors

Credit Risk and Risk Neutral Default Probabilities: Information About Rating Migrations and Defaults,” working paper

Default probabilities are important to the credit markets. Changes in default probabilities may forecast credit rating migrations to other rating levels or to default. Such rating changes can affect the firm’s cost of capital, credit spreads, bond returns, and the prices and hedge ratios of credit derivatives. While rating agencies such as Moodys and Standard & Poors compute historical default frequencies, option models can also be used to calculate forward looking or expected default frequencies. In this paper, we compute risk neutral probabilities or default (RNPD) using the diffusion models of Merton (1974) and Geske (1977). It is shown that the Geske model produces a term structure of RNPD’s, and the shape of this term structure may forecast impending credit events. Next, it is shown that these RNPD’s serve as bounds to estimates of actual default probabilities. Furthermore, the RNPD’s exhibit the same comparative statics as the estimates of actual default probabilities. Also, the risk neutral default probabilities may be more accurately estimated than actual default probabilities because they do not require an estimate of the firm’s drift. Given these similarities and advantages of RNPD’s, their estimates may possess significant information about credit events. To confirm this an event study of the relation between RNP

The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors

This paper analyzes the components of corporate credit spreads. The analysis is based on a structural model that can offer a framework to understand the decomposition. The paper contends that default risk may correctly represent only a small portion of corporate credit spreads. This idea stems both from empirical evidence and from the following theoretical assumptions underlying contingent claim models of default: that markets for corporate stocks and bonds are (i) perfect, (ii) complete, and (iii) trading takes place continuously. Thus, in these models there are no transaction or bankruptcy costs, no tax effects, no liquidity effects, no jump effects reflecting market incompleteness, and no market risk factors effecting the pricing of corporate stocks or bonds. The paper starts with the use of a modified version of the Black-Scholes-Merton diffusion based option approach. We estimate corporate default spreads as simply a component of corporate credit spreads using data from November 1991 to December 1998, which includes the Asian Crisis in the Fall, 1998. First we measure the difference between the observed corporate credit spreads and option based estimates of default spreads. We define this difference as the residual spread. We show that for AAA (BBB) firms only a small percentage, 5% (22%), of the credit spread can be attributed to default risk. We show that recovery risk also cannot explain this residual spread. Next, we show that state taxes on corporate bonds also cannot explain the residual. We note that the pure diffusion assumption may lead to underestimates of the default risk. In order to include jumps to default, we next estimate what combined jump-diffusion parameters would be necessary to force default spread to eliminate the residual spread. In each rating class on average firms would be required to experience annual jumps that decrease firm value by 20% and increase stock volatility by more than 100% over their observed volatility in order to eliminate the residual spread. We consider this required increase in stock volatility to be unrealistic as the sole explanation of the residual spread. So next we consider whether the unexplained component can be partly attributable to interest rates, liquidity, and market risk factors. We find the following empirical results: i) increases in liquidity as measured by changes in each firm’s trading volume significantly reduces the residual spread, but does not alter the default spread; ii) increases in stock market volatility significantly reduces the residual spread by increasing the default spread relative to the credit spread, and iii) increases in stock market returns significantly increases the residual spread by reducing the default spread relative to the credit spread. This paper concludes that credit risk and credit spreads are not primarily explained by default and recovery risk, but are mainly attributable to taxes, jumps, liquidity, and market risk factors