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The Effects of Default Correlation on Corporate Bond Credit Spreads

The tendency for firms' defaults to cluster is a widely accepted phenomenon in corporate bond and credit derivatives markets. The general observation is that regardless of the state of the economy there is some average number of firms that default each period, and intermittently there are sharp increases in the number of defaults. These spikes, or default clusters, are not persistent and the number of defaults readily reverts to the pre-cluster average.

Modelling this phenomenon plays a prominent role in bond risk management and in the valuation of credit derivatives, such as collateralized debt obligations (CDOs), and it is this phenomenon that is typically modelled by a default correlation parameter. The objective of this paper is to examine the relationship between this phenomenon and the cross-sectional variation of corporate bond credit spreads.

I show that corporate bond credit spreads are increasing in default correlation, as implied from the collateralized debt obligation market. This relationship holds for both a model implied measure of default correlation and a CDO tranche spread of-spreads proxy of default correlation. Specifically, using monthly data spanning January 2004 to September 2008, I empirically show that a one basis point decrease in the CDO tranche spread of-spreads translates into a 0.91 basis point increase in 5-year credit spreads and a 0.94 basis point increase in 10-year credit spreads; this after controlling for the risk-free term structure of interest rates, equity market returns and volatility, and firm e ffects.

The CDO tranche spread-of-spreads is the diff erence between the equity tranche spread (highest default risk) and the super-senoir tranche spread (lowest default risk). I demonstrate that it is decreasing in default correlation. Further to showing that corporate bond credit spreads are increasing in default correlation, I use principal component analysis to show that my decomposition residuals do not contain a missing systematic factor. This result adds to the growing body of literature that argues against the Collin-Dufresne, Goldstein, and Martin (2001) claim that there is a missing systematic credit spread factor.

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The Effects of Default Correlation on Corporate Bond Credit Spreads