{"id":6767,"date":"2009-06-02T22:44:18","date_gmt":"2009-06-03T02:44:18","guid":{"rendered":"http:\/\/www.prefblog.com\/?p=6767"},"modified":"2009-06-02T22:44:18","modified_gmt":"2009-06-03T02:44:18","slug":"yield-spreads-default-risk","status":"publish","type":"post","link":"https:\/\/prefblog.com\/?p=6767","title":{"rendered":"Yield Spreads & Default Risk"},"content":{"rendered":"

The Anginer and Y\u0131ld\u0131zhan paper recently discussed on PrefBlog<\/a> that attempted to corellate credit spreads with equity returns referenced a paper by Jing-zhi Huang and Ming Huang titled How Much of Corporate-Treasury Yield Spread is Due to Credit Risk?: A New Calibration<\/a>, presented at the 14th Annual Conference on Financial Economics and Accounting:<\/p>\n

No consensus has yet emerged from the existing credit risk literature on how much of the observed corporate-Treasury yield spreads can be explained by credit risk. In this paper, we propose a new calibration approach based on historical default data and show that one can indeed obtain consistent estimate of the credit spread across many different economic considerations within the structural framework of credit risk valuation. We find that credit risk accounts for only a small fraction of the observed corporate-Treasury yield spreads for investment grade bonds of all maturities, with the fraction smaller for bonds of shorter maturities; and that it accounts for a much higher fraction of yield spreads for junk bonds. We obtain these results by calibrating each of the models \u2013 both existing and new ones \u2013 to be consistent with data on historical default loss experience. Different structural models, which in theory can still generate a very large range of credit spreads, are shown to predict fairly similar credit spreads under empirically reasonable parameter choices, resulting in the robustness of our conclusion.<\/p><\/blockquote>\n

They note:<\/p>\n

One common finding from these studies is that the average historical default loss rate for corporate bonds is typically much smaller than the observed corporate-Treasury yield spreads, and is only a small fraction of the yield spreads for investment-grade bonds. Figure 1 provides a visual summary of this finding.<\/p><\/blockquote>\n

<\/a>
Click for big<\/i><\/div>\n

They point out:<\/p>\n

This fact alone, however, should not lead one to automatically conclude that credit risk accounts for only a small fraction of the observed yield spreads for investment grade bonds. After all, the expected default loss rate is only part of the (promised) credit yield spread; the other part is the credit risk premium, defined as the difference between the expected realized return of a defaultable bond and that of a comparable Treasury bond. The credit risk premium is required by investors because the uncertainty of default loss should be systematic\u2014bondholders are more likely to suffer default losses in bad states of the economy. Moreover, precisely because of the tendency for default events to cluster in the worst states of the economy, the credit risk premium can be potentially very large. In fact, some of the models considered in this paper can indeed generate credit risk premia that are large enough to explain the difference between the observed corporate yield spreads and historical default loss rate, provided that certain parameter choices are made. The key question, however, is whether any model can generate such large credit risk premia under empirically reasonable parameter choices. This question is the main focus of our paper.<\/p><\/blockquote>\n

They conclude:<\/p>\n

We conclude that, for investment grade bonds (those with a credit rating not lower than Baa) of all maturities, credit risk accounts for only a small fraction\u2014typically around 20%, and, for Baa-rated bonds, in the 30% range\u2014of the observed corporate-Treasury yield spreads, and it accounts for a smaller fraction of the observed spreads for bonds of shorter maturities. For junk bonds, however, credit risk accounts for a much larger fraction of the observed corporate-Treasury yield spreads.<\/p><\/blockquote>\n","protected":false},"excerpt":{"rendered":"

The Anginer and Y\u0131ld\u0131zhan paper recently discussed on PrefBlog that attempted to corellate credit spreads with equity returns referenced a paper by Jing-zhi Huang and Ming Huang titled How Much of Corporate-Treasury Yield Spread is …<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[12],"tags":[],"class_list":["post-6767","post","type-post","status-publish","format-standard","hentry","category-interesting-external-papers"],"_links":{"self":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts\/6767","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=6767"}],"version-history":[{"count":0,"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts\/6767\/revisions"}],"wp:attachment":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=6767"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=6767"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=6767"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}