The authors use bond prices and credit default swap premiums to determine the
composition of corporate yield spreads. Although default risk accounts for most
of the spread, there is also a significant time-varying nondefault component
directly related to liquidity effects. The results extend earlier research that
considers the market price of credit risk to be higher than implied by select
structural models.
The authors use credit default swap premiums and associated bond price data to measure
the default and nondefault components of bond spreads. Because, contrary to industry
assumption, observed credit default swap premiums do not provide direct, unbiased
measures of bond default spread components (Duffie,
Journal
devise a reduced-form model after Duffie and Singleton (
Finance
spreads implied by default swap premiums. Key attributes of the model include: an
interest rate process; a Poisson, or jump, process regulating default intensity; and a
convenience yield process. Each of the processes is stochastic and independently
distributed. The great benefit of the model's configuration is that it easily enables
closed-form solutions for bond and swap expectations expressions.
The authors first apply their method to Enron Corporation corporate bond yields and
credit default swap premiums over the year preceding the company's default and
bankruptcy filing. Weekly observations are drawn from a cross section of Enron
Corporation bonds surrounding the five-year area of the corresponding default swap, and
for each observation date, a risk-free discount function is alternately generated from
Treasury, Resolution Funding Corporation, and swap curves. The authors show that the
implied default intensity, which spikes sharply weeks before bankruptcy, is curve
invariant. The liquidity process, consistent over much of the sample period, also falls
sharply as the implied default probability intensifies.
With the model estimated, the authors directly solve for the yield spread components. The
nondefault component equals the actual bond yield less a model-implied,
liquidity-adjusted yield. The default component, then, may be given by subtracting the
nondefault component from the bond spread. The authors calculate that, on average, the
default component exceeds the swap premium by 6 bps and represents up to 90 percent of
the total bond spread. There is, however, significant time variation in both the credit
default swap bias and the default component spread percentage.
Applying their technique more broadly, using swap premiums and bond prices of some 68
firms, the authors find that the default proportion of corporate spreads averages from
50 percent to at least 83 percent across ratings and risk-free curves. They also verify
that a sizable nondefault component exists that is quickly mean reverting but, unlike
the default component, exhibits little ratings-related variation. Prompted by recent
research, the authors test whether the cross-sectional differences of the nondefault
component are related to illiquidity or tax effects. Weak evidence exists supporting the
tax hypothesis, whereas bond-specific illiquidity features clearly influence nondefault
spreads. Overall or common changes in nondefault components, moreover, are related to
macroeconomic liquidity effects and T-bond specialness. Finally, the incremental costs
from liquidity effects may explain why firms use less than the model-implied levels of
debt in their capital structures.