The Term Structure of Credit Spreads on Euro Corporate Bonds

Abstract

Although there is a broad literature on structural credit risk models, there has been little empirical testing of these models.In this paper we examine the term structure of credit spreads on euro corporate bonds and the empirical validation of structural credit risk models.The latter provide a framework to analyze the main determinents of credit spreads.Using a dataset of 1577 investment grade corporate and 250 AAA rated government bonds, we first estimate the term structure of credit spreads for di.erent (sub)rating categories with an extension of the Nelson-Siegel method.Within each rating category, credit spreads on plus rated bonds have significantly higher credit spreads than minus rated bonds.According to the structural models, the results indicate that credit spread changes are significantly negatively correlated with changes in the level and the slope of the default-free term structure.While changes in the slope a.ect all rating categories, changes in the level are more important for higher rated bonds (AAA and AA).The stock return and the implied volatility of the stock price seem to significantly influence credit spread changes.The lower the rating category and the longer the maturity of the bond the stronger both e.ects.For BBB rated bonds, changes in liquidity -measured as the bid-ask spread- significantly influence credit spread changes.Higher rated bonds (AAA and AA) are also driven by past credit spread changes.capital markets;risk management;bonds;volatility;credit risk