There’s an interesting paper by Deniz Anginer and Çelim Yıldızhan (both of U of Michigan), titled Pricing of Default Risk Revisited: Corporate bond spread as a proxy for default risk:
This paper explores the pricing of default risk in the cross section of equity returns using US corporate bond data during the 1986 to 2006 time period. Although financial theory suggests a positive relationship between default risk and equity returns, recent empirical papers find anomalously low returns for stocks with high probabilities of bankruptcy. In this paper we use a market based measure – corporate credit spreads – to proxy for default risk. We show that credit spreads predict corporate defaults better than previously used measures, such as, bond ratings and accounting based parameters. We do not find default risk to be significantly priced in the cross-section of equity returns. There is also no evidence of firms with high default risk delivering anomalously low returns. Our results suggest that default risk is not a priced risk factor
They review the literature:
There is now a significant body of theoretical research that shows that default-risk constitutes a considerable portion of credit spreads. Berndt, Douglas, Duffie, Ferguson, and Schranz (2005) and Saita (2006), for instance, report that the compensation demanded by investors for being exposed to credit risk, above and beyond expected default losses, is substantial. On the empirical side, Elton et al. (2001) report that default -risk related premium in credit spreads accounts for 19% to 41% of spreads depending on company rating. Driessen (2003) also finds that default risk accounts for 18% (AA rated bonds) and as high as 52% (BBB rated bonds) of the corporate spread. Huang and Huang (2003) using the Longstaff-Schwartz model find that distress risk accounts for 39%, 34%, 41%, 73%, and 93% of the corporate spread respectively for bonds rated Aa, A, Baa, Ba, and B. Longstaff, Mithal, and Neis (2005) use the information in credit-default swaps (CDS) to obtain direct measures of the size of the default and non-default components in corporate spreads. They find that the default component represents 51 percent of the spread for AAA/AA rated bonds, 56 percent for A-rated bonds, 71 percent for BBB-rated bonds, and 83 percent for BB-rated bonds.
Happiness is picking up credit for free:
there is much variation in credit spreads within a rating group. The correlation between credit spreads and ratings is only 45%. AA bonds have an average credit spread of 77.51 basis points with a standard deviation of 98 basis points. A one standard deviation move in credit spreads would firmly take this bond’s rating to a BBB rating which is 6 rating levels down from AA. These results indicate that measuring default risk through company ratings can yield misleading results.
Mind you, I’m a little suspicious of their methodology:
Table 11 reports summary statistics for credit spreads by rating category. The benchmark risk-free yield is the yield of the closest maturity treasury. We include only straight fixed-coupon corporate bonds for the January 1974-December 2006 time period. Bonds for financial firms are excluded. The spreads are given in annualized yield in basis points and ratings in this sample come from Standard and Poor’s.
That’s a long time-frame, with a very wide variety of market conditions. I suspect that disaggregating the data would reduce the variance of spreads within a rating category considerably. Fortunately for my willingness to consider their results, the corellation between credit spreads and equity returns was examined using portfolios that were rebalanced monthly.
… and the authors conclude:
In this paper we examine the pricing of default risk in equity returns. Our contribution to this literature is two-fold. First, ours is the first paper to use bond spreads to measure the ex-ante probability of default risk. This measure has several advantages over others that have been used in the literature. It is available in high frequency, it is model and assumption free and reflects the market consensus of the credit quality of the underlying firm. Most importantly in section 3.2 we show that credit spread drives out the significance of most of the other measures in hazard rate regressions that are used to predict corporate defaults. Second, contrary to previous findings, we show that default risk is not priced negatively in the cross section of equity returns. Portfolios sorted on credit spreads do not deliver significant positive or negative returns after controlling for the well known risk factors. Cross-sectional regressions also show no anomalous relationship between credit spreads and equity returns. We find that credit ratings are priced negatively in the cross-section, but credit spreads are not, even though credit spreads predict bankruptcies better than bond ratings. Our findings challenge the previous studies that have found an anomalous relationship between credit risk and equity returns. We believe that our analysis is the right step towards finding a more appropriate measure of systematic default risk that can explain the cross section of equity returns in line with the rational expectations theory.
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