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Time-Series Estimation of Aggregate Corporate Bond Credit Spreads

Assessing and managing the credit risk of risky corporate debt instruments has become a major area of interest and concern to academics, practitioners and regulators in the past decade, especially in the aftermath of a series of credit crises such as the Russian default and the Enron and the WorldCom collapses. In the academic field, there has been a fast growing literature on models of credit risk measurement and management.

In the industry, the market in credit risk transfer, especially the market of corporate credit derivatives, has been expanding rapidly, and is becoming increasingly relevant in the business of commercial banks, insurance companies, pension/investment funds and hedge funds. The market in credit risk transfer is evolving into an important fragment of the global financial markets.

To help investors keep up with the latest information in the different segments of the credit markets and assist client in trading and managing portfolios, major investment banks and rating agencies have constructed various credit indices to serve as market indicators and as references for structured credit products. These credit indices are either based on the corporate-Treasury credit spread (such as the credit spread indices constructed by Lehman Brothers, Salomon Smith Barney, Merrill Lynch) or the newly available credit default swap spread data.

For risk management purposes, investors holding a large corporate bond portfolio may find it more convenient to hedge themselves against changes in credit risk at the aggregate level instead of at individual issue level. For example, the group of banks launching the iBoxx company in 2001 have integrated a variety of iBoxx indices, including the credit default swap (CDS) indices, into their research products and used those indices as a basis for research recommendation. Given the surging demand for portfolio credit risk management, it would not surprising to see these credit index based products gaining more popularity in the near future.

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Time-Series Estimation of Aggregate Corporate Bond Credit Spreads