Bridge over ocean
1 September 1994 Financial Analysts Journal Volume 50, Issue 5

Using Default Rates to Model the Term Structure of Credit Risk

  1. Jerome S. Fons
As the maturity of a corporate bond increases, its credit spread versus a comparable-maturity Treasury bond may widen or narrow, depending on the bond's credit risk. This bond-pricing model illustrates the relationship between credit spread, estimated default likelihood, and recovery rate. It explains observed patterns in credit spreads, by rating category, as bond maturity varies. Patterns in marginal default rates reflect a typical firm's life cycle. Lower rated (smaller, younger, more heavily leveraged) issuers tend to have wider credit spreads that narrow with maturity. Higher rated (more mature, stable) firms tend to have narrower credit spreads that widen with maturity.
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