Corporate Yield Spreads: Default Risk or Liquidity? New Evidence - - PowerPoint PPT Presentation

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Corporate Yield Spreads: Default Risk or Liquidity? New Evidence - - PowerPoint PPT Presentation

Nov 19, 2022 492 likes •783 views

Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market Professor Francis Longstaff UCLA/Anderson School Introduction How are corporate bonds priced in the market? In theory, corporate

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Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market

Professor Francis Longstaff UCLA/Anderson School

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Introduction

How are corporate bonds priced in the market? In theory, corporate spreads should be fully explained by default risk. In practice, many studies find that default risk only explains a small (5 to 25 %) fraction of corporate spreads.

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Introduction

We use the information in credit-default swaps to directly measure the size of the default component in corporate spreads. This also allows us to study the properties of the nondefault component of corporate spreads.

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CDS Contracts

A credit-default swap has two legs. Buyer of protection pays a quarterly annuity until either end of contract or a default. If there is a default, buyer of protection can put bond back to protection seller at its par value. We use an extensive data set on CDS prices and corporate bond yield provided by Citigroup global credit derivatives business.

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The Approach

We use closed-form Duffie-Singleton model to value bonds and CDS contracts. We fit the model simultaneously to corporate yields and CDS premia. We use fitted model to imply the size of the default component for 76 firms. We study the properties of the default and nondefault components of corporate spreads.

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Findings

Most of the spread is due to default risk. The nondefault component is due mostly to a general bond market liquidity factor, and individual corporate bond illiquidity features.

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A CDS Term Sheet

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Term Sheet

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Term Sheet

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Term Sheet

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Percent due to Credit

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