Abstract
We estimate long-term expected credit spreads and excess returns for multiple US corporate bond ratings and maturities and extend the findings of Giesecke et al. (Journal of Financial Economics, 102(2), 233–250, 2011). We develop a risk-neutral valuation model and correct the credit spreads for the well-known “credit spread puzzle”. We calibrate the model on data from 1919 to 2014, which is much longer than used in most other papers analyzing expected credit spreads and excess returns. Our model-implied expected credit spread term structures are in line with the results in the literature.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Notes
- 1.
- 2.
The assumption of fractional recovery of face value assumption is supported by empirical evidence; see Bakshi et al. (2001).
- 3.
There exists considerable evidence of a short-term liquidity premium in the US sovereign debt market. See, for example, Nagel (2016) and the references therein.
- 4.
Note that Tn ≡ T with T equal to the bond maturity.
- 5.
The historical interest rates obtained from GFD before April 1953 are based on Homer and Sylla (1996).
- 6.
The yields of the composite of long-term government bonds index of Merrill Lynch are almost identical to the ones from the FED.
- 7.
In our case, this is the 20-year cumulative default probability of the CCC rating.
- 8.
Note that the price of risk parameter has no unit as it is a multiplication factor between the physical and risk-neutral hazard rates. For example, if the price of risk parameter is 4 then this means the risk-neutral investors perceive the risk-neutral default probabilities 4 times larger than the physical default probabilities.
- 9.
Hull et al. (2005) find expected annualized excess returns of 0.81%, 0.86%, 1.12%, 1.58%, 2.03%, 1.36%, and 3.07% for the AAA, AA, A, BBB, BB, B, and CCC ratings, respectively. The authors define these excess returns over the swap rate.
- 10.
Giesecke et al. (2011) report an expected annualized excess return of about 0.8%, which is based on a recovery assumption of 50%, an average credit spread of 1.53%, and average default loss rate of 1.5% measured over the period 1866–2008. However, the authors find that the annual default loss rate decreases by half to roughly 0.75% for the 1900–2008 period, which is a period that better corresponds to our 1919–2014 sample. Taking their finding of an average credit spread of 1.53% and default losses of 0.75% and our recovery assumption of 35% gives an expected excess return of 1.04%.
References
Bakshi, G., Madan, D. B., & Zhang, F. X. (2001). Understanding the role of recovery in default risk models: Empirical comparisons and implied recovery rates. Finance and Economics Discussion Series, 2001–37, Federal Reserve Board of Governors, Washington DC.
Bohn, J. (1999). Characterizing credit spreads. Haas School of Business University of California Working Paper.
Bongaerts, D., De Jong, F., & Driessen, J. (2011). Derivative pricing with liquidity risk: Theory and evidence from the credit default swap market. Journal of Finance, 66(1), 203–240.
Chen, L., Lesmond, D. A., & Wei, J. (2007). Corporate yield spreads and bond liquidity. Journal of Finance, 62(1), 119–149.
Chen, H., Sloan, I. T., Cui, N. R., & Milbrandt, N. K. (2014). Quantifying liquidity and default risks of corporate bonds over the business cycle. National Bureau of Economic Research Working Paper No. 20638.
De Jong, F., & Driessen, J. (2012). Liquidity risk premia in corporate bond markets. Quarterly Journal of Finance, 2(2), 1–34.
Diebold, F. X., & Li, C. (2006). Forecasting the term structure of government bond yields. Journal of Econometrics, 130(2), 337–364.
Driessen, J. (2005). Is default event risk priced in corporate bonds? Review of Financial Studies, 18(1), 165–195.
Duffie, D., & Singleton, K. J. (1999). Modeling term structures of defaultable bonds. Review of Financial Studies, 12(4), 687–720.
Elton, E. J., Gruber, M. J., Agrawal, D., & Mann, C. (2001). Explaining the rate spread on corporate bonds. Journal of Finance, 56(1), 247–277.
Fons, J. S. (1994). Using default rates to model the term structure of credit risk. Financial Analysts Journal, 50(5), 25–33.
Giesecke, K., Longstaff, F. A., Schaefer, S., & Strebulaev, I. (2011). Corporate bond default risk: A 150-year perspective. Journal of Financial Economics, 102(2), 233–250.
Helwege, J., & Turner, C. (1999). The slope of the credit yield curve for speculative grade issuers. Journal of Finance, 54(5), 1869–1884.
Homer, S., & Sylla, R. E. (1996). A history of interest rates. New Brunswick, NJ: Rutgers University Press.
Huang, J., & Huang, M. (2012). How much of the corporate-treasury yield spread is due to credit risk? Review of Asset Pricing Studies, 2(2), 153–202.
Hull, J. C., Predescu, M., & White, A. (2005). Bond prices, default probabilities and risk premiums. Journal of Credit Risk, 1(2), 53–60.
Ilmanen, A. (2011). Expected returns: An investor’s guide to harvesting market rewards. Hoboken, NJ: John Wiley & Sons.
Lando, D. (1998). On Cox processes and credit risky securities. Review of Derivatives Research, 2(2–3), 99–120.
Longstaff, F. A., Mithal, S., & Neis, E. (2005). Corporate yield spreads: Default risk or liquidity? New evidence from the credit default swap market. Journal of Finance, 60(5), 2213–2253.
Merton, R. (1974). On the pricing of corporate debt: The risk structure of interest rates. Journal of Finance, 29(2), 449–470.
Nagel, S. (2016). The liquidity premium of near-money assets. Quarterly Journal of Economics, 131(4), 1927–1971.
Ng, K.-Y., & Phelps, B. D. (2011). Capturing credit spread premium. Financial Analysts Journal, 67(3), 63–75.
O’Kane, D. (2010). Modelling single-name and multi-name credit derivatives. John Wiley & Sons.
Ou, S. (2015). Annual Default Study: Corporate default and recovery rates 1920–2014. Moody’s Investor Services.
Sarig, O., & Warga, A. (1989). Some empirical estimates of the risk structure of interest rates. Journal of Finance, 44(5), 1351–1360.
Acknowledgments
I thank Alex Boer, Bert Kramer, and Martin van der Schans for very helpful comments and suggestions. Any remaining errors are my own.
Author information
Authors and Affiliations
Corresponding author
Editor information
Editors and Affiliations
Appendix
Appendix
Rights and permissions
Copyright information
© 2018 The Author(s)
About this chapter
Cite this chapter
Hennink, E. (2018). Long-Term Expected Credit Spreads and Excess Returns. In: Bulusu, N., Coche, J., Reveiz, A., Rivadeneyra, F., Sahakyan, V., Yanou, G. (eds) Advances in the Practice of Public Investment Management. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-90245-6_8
Download citation
DOI: https://doi.org/10.1007/978-3-319-90245-6_8
Published:
Publisher Name: Palgrave Macmillan, Cham
Print ISBN: 978-3-319-90244-9
Online ISBN: 978-3-319-90245-6
eBook Packages: Economics and FinanceEconomics and Finance (R0)