Ebook On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle
It is well-known that standard structural models of default predict counterfactually low credit spreads for corporate debt, especially for investment grade bonds of short maturity. Early work includes Jones, Mason and Rosenfeld (1984), who find that the Merton (1974) model generates yield spreads that fall far below empirical observation for investment grade firms.
Although subsequent work (e.g., Eom, Helwege and Huang (2004)) has found that various structural models can generate very diverse predictions for credit spreads, Huang and Huang (HH 2003) demonstrate that once these various models are calibrated to be consistent with historical default and recovery rates, they all produce very similar credit spreads that fall well below historical averages. For example, HH report that the theoretical average 4-year (Baa Treasury) spread is approximately 32 basis points (bp) and relatively stable across models. This contrasts sharply with their reported historical average (Baa-Treasury) spread of 158 bp. Similarly, HH find that the theoretical average 4-year Aaa-Treasury spread is about 1 bp, well below their reported historical average of 55 bp.
The typical ‘explanation’ for the large discrepancy between observed and theoretically predicted spreads is that these theoretical models only account for credit risk. That is, these models choose to ignore other factors that affect corporate bond prices, such as taxes, call/put/conversion options and the lack of liquidity in the corporate bond markets. However, assuming that the component of the credit spread due to these issues is of similar magnitude for Aaa and Baa bonds, then the (Baa-Aaa) spread should be mostly due to credit risk. Note, however, that the HH results reported above imply a predicted (Baa-Aaa) spread of (32 - 1) 31 bp, far short of the observed (158 - 55) 103 bp. As such, the findings of HH suggest that expected returns on a portfolio that is long Baa bonds and short Aaa bonds are rather large compared to the underlying risks involved. We refer to this result as the ‘credit spread puzzle’.
We note that this ‘credit spread puzzle’ is reminiscent of the so-called equity premium puzzle in that the historical returns on equity also appear to be too high for the risks involved. Now, since corporate bonds and equities are both claims to the same firm value, they clearly share many of the same systematic risk sources. As such, it seems natural to ask whether these two puzzles are related. This question is the focus of our paper.
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