Diversification with idiosyncratic credit spreads: a pooled estimation on heterogeneous panels

Following the method of Pesaran, Shin and Smith (1999), this study extends the results of Sun, Lin and Nieh (2007) to investigate the risk diversification issue of individual corporate bonds in portfolios. This is one of the few studies on the decomposition of individual corporate yield spreads. Specifically we adopt the robust econometric method of ARDL-based Pooled Mean Group cointegration analysis on panels of corporate bond data which yields results with rich economic implications for fixed income portfolio management. Empirical decomposition of yield spreads indicates, on the individual corporate bond level, that the idiosyncratic component serves as a good vehicle for risk diversification while considering long run market behavior. In the long run systematic credit spreads are found to be consistent with the agency hypothesis where higher interest rate raises endogenous default risk and it is particularly meaningful for the Taiwanese capital market. Option hypothesis of the structural approach is still valid in the short run in predicting yield spreads to be inversely related to interest rate. Our findings contribute in general to the risk practice of bond portfolio diversification. In particular, the pooled estimation we conducted proves to be superior in working with individual corporate bond data panels and helps related studies in the area.