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Long run credit risk diversification: empirical decomposition of corporate bond spreads

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  • Sun, David
  • Lin, William
  • Nieh, Chien-Chung

Abstract

Following the reduced-form models of Duffee (1999) and Jarrow, Lando and Yu (2003), this study investigates the risk diversification issue of corporate bond portfolios. Considering especially long run market behavior, our empirical decomposition of corporate bond yield spreads indicates that the idiosyncratic component serves as a good vehicle for risk diversification. Moreover, the diosyncratic spread provides significant inferences about observed conditional corporate bond default rate, while full spread does not. Applying an affine model from Duffie and Singleton (1999), we find that the idiosyncratic credit spreads do not respond empirically to Treasury yields, unlike what is suggested in the structural model of Longstaff and Schwartz (1995) and literatures that follow. Systematic credit spreads are however positively related to Treasury yields in the long-run, but negatively so in the short run, suggesting the validity of both the tax and the option hypotheses. A long-run and optimal decomposition scheme yields an idiosyncratic credit spread measure at a median of 60 b.p. for the Baa index and is specifically compatible with Duffee’s model. It is insensitive to interest rate in the short-run, but would rise slightly with a positive shock in the long run at a rate of one to a hundred. Our findings in the study contribute to the risk practice of bond portfolio diversification.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 37283.

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Date of creation: Oct 2007
Date of revision: Jul 2008
Publication status: Published in Review of Securities and Futures Markets 20.2(2008): pp. 135-187
Handle: RePEc:pra:mprapa:37283

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Keywords: bond pricing; cointegration; credit risk; credit spread; diversifiable risk;

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References

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  1. Robert A. Jarrow & David Lando & Fan Yu, 2005. "Default Risk And Diversification: Theory And Empirical Implications," Mathematical Finance, Wiley Blackwell, Wiley Blackwell, vol. 15(1), pages 1-26.
  2. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 247-277, 02.
  3. Gregory R. Duffee, 1996. "Estimating the price of default risk," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 96-29, Board of Governors of the Federal Reserve System (U.S.).
  4. Liu, Jun & Longstaff, Francis A. & Mandell, Ravit E., 2004. "The Market Price Of Risk In Interest Rate Swaps: The Roles Of Default And Liquidity Risks," University of California at Los Angeles, Anderson Graduate School of Management, Anderson Graduate School of Management, UCLA qt5z42g22g, Anderson Graduate School of Management, UCLA.
  5. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 50(1), pages 53-85, March.
  6. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, American Finance Association, vol. 56(6), pages 2177-2207, December.
  7. Jarrow, Robert A. & Turnbull, Stuart M., 2000. "The intersection of market and credit risk," Journal of Banking & Finance, Elsevier, Elsevier, vol. 24(1-2), pages 271-299, January.
  8. BAI, Jushan & PERRON, Pierre, 1998. "Computation and Analysis of Multiple Structural-Change Models," Cahiers de recherche, Universite de Montreal, Departement de sciences economiques 9807, Universite de Montreal, Departement de sciences economiques.
  9. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 29(2), pages 449-70, May.
  10. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, American Finance Association, vol. 53(6), pages 2225-2241, December.
  11. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
  12. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  13. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, American Finance Association, vol. 50(3), pages 789-819, July.
  14. Barnhill Jr., Theodore M. & Joutz, Frederick L. & Maxwell, William F., 2000. "Factors affecting the yields on noninvestment grade bond indices: a cointegration analysis," Journal of Empirical Finance, Elsevier, Elsevier, vol. 7(1), pages 57-86, May.
  15. Saunders, Anthony & Srinivasan, Anand & Walter, Ingo, 2002. "Price formation in the OTC corporate bond markets: a field study of the inter-dealer market," Journal of Economics and Business, Elsevier, Elsevier, vol. 54(1), pages 95-113.
  16. Thomas C. Wilson, 1998. "Portfolio credit risk," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Oct, pages 71-82.
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Cited by:
  1. Sun, David & Tsai, Shih-Chuan, 2013. "Diversifying Risks in Bond Portfolios: A Cross-border Approach," MPRA Paper 44767, University Library of Munich, Germany, revised 09 Jan 2014.

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