The credit spread puzzle
Why are spreads on corporate bonds much wider than would be implied by expected losses from default? Previous explanations of this puzzle have assumed that investors can diversify away the risk that actual losses in a corporate bond portfolio will exceed expected losses. However, the skewness in the distribution of corporate bond returns implies that achieving such diversification will require an extraordinarily large portfolio. We present evidence from the market for collateralised debt obligations suggesting that such large portfolios are unattainable. Hence, investors always face the risk that actual losses will exceed expectations. Credit spreads are so wide because they compensate investors for such risk.
Volume (Year): (2003)
Issue (Month): (December)
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- Paul Schultz, 2001. "Corporate Bond Trading Costs: A Peek Behind the Curtain," Journal of Finance, American Finance Association, vol. 56(2), pages 677-698, 04.
- Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
- Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02.
- Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000. "Stability of rating transitions," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 203-227, January.
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