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Corporate bond credit spreads Mystery of the latest research and future prospects

Author: SunKe From: www.yourpaper.net Posted: 2009-03-31 20:32:25 Read:
Abstract: The huge difference between the corporate bond credit spreads and expected default loss is caused by the growing concern of the people of the mystery of the "credit spread". One of the mystery of the "credit spread" the representative explained the credit spread decomposition theory, the theory of the latest research has touched the tax, risk premium and liquidity premium; representative explained to credit risk diversification dilemma theory including system risk undiversifiable and risk diversification is difficult dispersible. In addition, the of credit spreads mystery has the transition from a developed bond market to the emerging bond market, and remains to be further studied.
Keywords: credit spreads; credit spread decomposition; credit risk dispersion
Credit spreads of corporate bonds mystery "

"credit spread" is the order to compensate for the risk of default, investors demand additional revenue higher than the income of government bonds with the same maturity corporate bonds, generally the same remaining maturities and cash flow structure of corporate bonds and the difference between the yield to maturity of government bonds as credit spreads. In the bond market, credit spreads as the representatives of the credit risk of corporate bonds, the credit risk of corporate bonds is inferred by observing changes in credit spreads. But credit spread is used to compensate for credit risk, although it is generally considered, along people still difficult to explain the exact relationship between credit spreads and credit risk. In fact, credit spreads for corporate bonds spread many times greater than the expected loss given default contained. For example, in 1997-2003, the period between the United States three years to five years the average credit spread of BBB-rated corporate bonds to 170 basis points per year. However, in the same period, the average annual losses caused by the breaching of only 20 basis points, credit spreads as much as eight times larger than the expected loss given default. This huge gap between the credit spreads and expected loss given default is the so-called "the credit spreads mystery."
By Merrill Lynch option-adjusted bond spread index (OAS), you can calculate the average credit spread of corporate bonds of different credit rating of the United States from January 1997 to August 2003 period, as shown in Table 1. Table 1 lists the corresponding estimate of the expected loss given default. Visible, the AAA level short-term corporate bonds (a period of 1-3 years), the average credit spread of about 50 basis points, for a period of 7 to 10 years of corporate bonds, the average credit spread of 74 basis points. Starting with the BBB, low credit grade corporate bonds, credit spreads rapidly increased. Concern is the expected default losses are only a small part of the credit spread for corporate bonds of all credit levels and duration. For example, the BBB credit rating for a period between 3 to 5 years of corporate bonds, the expected default loss of only 20 basis points, while the average credit spread of 171 basis points. Meanwhile, with the reduction of credit rating, the absolute increase in the gap between the credit spreads and expected default loss. As shown in Table 1, the period of between 3 to 5 years of corporate bonds, for example, this gap increased 64 basis points from the AAA-rated corporate bonds to the same period of the B-grade bonds by 291 basis points.
Table 1 credit spreads and expected default loss compare































Credit
Level

The term of the bonds

1-3 years

3-5 years

5-7 years

7-10 years

Credit spreads

Expected loss

Credit spreads

Expected loss

Credit spreads

Expected loss

Credit spreads

Expected loss

AAA
AA
A
BBB
BB
B

49.50
58.97
88.82
168.99
421.2
760.84

0.06
1.24
1.12
12.48
103.09
426.16

63.86
71.22
102.91
170.89
364.55
691.81

0.18
1.44
2.78
20.12
126.74
400.52

70.47
82.36
110.71
185.34
345.37
571.94

0.33
1.86
4.71
27.17
140.52
368.38

73.95
88.57
117.52
179.63
322.32
512.43

0.61
2.7
7.32
34.56
148.05
329.4

Merrill Lynch Note: credit spread basis points is calculated from data from January 1997 to August 2003, the option adjusted spreads of U.S. corporate bonds average index.

"Mystery" of credit spreads

The credit spread expected loss given default of corporate bonds accounted for only a small fraction of the fact that people start looking for one of the mysteries of the source. Among them, the representative of the mystery of the "credit spread" to explain the credit spread decomposition theory and credit risk diversification dilemma theory.
A credit spread decomposition theory
Credit spread decomposition theory for a long time, Jones, Mason, and Rosenfeld (1984) [1] the first Merton (1974) [2 estimated] or claims for breach of contract spreads, the Merton model underestimates the corporate credit spreads, the actual breach spreads than credit spreads. Leland (1994) [3] extends Black and Cox (1976) model, the added advantage of tax liabilities and bankruptcy costs factors, found that the increase in the cost of the bankrupt makes corporate bonds Credit spreads expanded, the increase in the corporate tax narrowing credit spreads for corporate bonds, and thus the value of the bonds and the value of the assets of the company, the risk of default, taxes, bankruptcy costs and interest rates linked. Longstaff and Schwartz (1995) [4] Black and Cox (1976) model is extended from different angles, while adding the default risk and interest rate risk factors that when two the default risk of the company are the same, the differences in credit spreads depends on the correlation between the value of assets and changes in interest rates. Anderson and Sundaresan (1996) [5] restructuring an endogenously determined threshold and restructuring cash flow model, found credit spreads with increasing bankruptcy costs increase and increased by the impact of the company's leverage ratio and the degree of fluctuation in the value of the Company. They confirmed that by adding these costs, the predictive value of the credit spreads become more consistent with market observations.

Credit spread decomposition theory research has touched taxation, risk premium and liquidity premium. Elton et al (2001) [6] credit spreads for corporate bonds decomposition of expected losses, taxes and residuals three parts, test and then as time goes on residual the extent to spread changes can be explained by systematic risk factors, and the calculation of the risk premium. Gordon Delianedis and Robert Geske (2001) [7] to study the composition of the credit spreads of corporate bonds, concluded that the presence of credit risk and credit spreads are not primarily by the breach of contract risk caused mainly caused by the recovery rates, taxes, liquidity factors and market risk factors. Small part of default risk and recovery risk is the credit spreads of corporate bonds, while the main explanatory factors including tax default jumps, liquidity, market risk factors, as well as a small amount of the interest rate factor. Jing-zhi Huang and Ming Huang (2003) [8] found that the credit risk only explain the income between the daily observed all term investment-grade corporate bonds and government bonds spread small part, for a smaller proportion of the shorter term corporate bonds explain, explain the income spreads for junk bonds, credit risk more than a high proportion. Credit risk is the formation of one of the factors of the yield spread between corporate bonds and government bonds, and other factors, including poor mobility, some corporate bonds redeemable and convertible nature of the tax factors. Driessen (2003) [9] using and Elton et al (2001) different methods and data further decompose the credit spread, credit spread decomposition taxes, liquidity risk, systemic factors risk, default risk, and firm-specific risk, and he especially considering the impact of the liquidity premium. Table 3 Elton et al (2001) [6] and Driessen (2003) the [9] research Conclusions were compared.

1 Tax
The gains of the investment in corporate bonds is taxable, and the benefits of investment in government bonds is not taxed. Investors to compare different investment vehicles, investment income is based on after-tax income as the basis arbitrage theory is that the gains of corporate bonds to be higher to compensate for tax expenditures. In the United States, different states have different requirements for the maximum marginal tax rate of the corporate bonds, roughly in between 5% to 10%. Elton et al (2001)
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