Timevarying credit risk and liquidity premia in bond and cds markets
This paper shows that corporate credit risk premia vary substantially both over time and between bonds. It shows that the vast majority of this variation can be explained by expected losses, credit ratings, implied volatilities, investor clientele effects, consumer sentiment, and credit market liquidity.
Thus, a good starting point is to define a CDS. A CDS is insurance on a bond. Like any insurance contract, a CDS has both a buyer and a seller. For example, a pension fund that owns an IBM bond that matures in might be concerned that this bond will default.
Thus, it can buy a CDS on that bond from a hedge fund the seller. The buyer of the CDS pays the seller a regular premium, similar to an insurance premium.
If the bond defaults, the seller pays the buyer the difference between the face value of the bond and its market value — since this is the amount that the buyer has lost through the default.
What determines the price of the insurance contract, i. It comprises of two components:. The first component is the Expected Loss Rate. However, the CDS rate will typically be higher than the expected loss rate.
This difference is the Credit Risk Premium. The Credit Risk Premium arises for two reasons:. They find that corporate credit timevarying credit risk and liquidity premia in bond and cds markets premia vary substantially over time.
Its lowest level was 0. Figure 1 illustrates this substantial variation. While expected losses are relatively stable over time, the CDS rate fluctuates wildly. It is higher in recessions because they are more risky. Moreover, it is more countercyclical for investment grade bonds than high yield bonds. Since investment grade bonds are affected to roughly the same degree as high yield bonds, and they are less risky to begin with, the premium per unit of risk rises more in recessions.
In addition, corporate credit risk premia vary substantially between bonds. Without scaling by the Expected Loss Rate, the Credit Risk Premium is less than 10 basis points of bond principal for Aaa rated bonds, and more than basis points for Ca-C rated bonds.
This is logical, since lower-rated bonds are riskier. More surprising is the pattern when scaling by the Expected Loss Rate, i. Now, the scaled Credit Risk Premium is highest for mid-rated bonds 4. Scaled premia also vary across industries, hitting a high of 8. These differences can be largely explained by the difference in credit ratings between industries. Credit spreads, per unit of expected losses, are decreasing in expected losses. They thus consider two types of predictors for the ratio:.
Thus, the paper successfully opens the black box of what timevarying credit risk and liquidity premia in bond and cds markets the substantial variation in corporate credit risk premia, showing that these premia vary with firm-level and macroeconomic determinants in a way consistent with existing theories and economic intuition. It comprises of two components: The Credit Risk Premium arises for two reasons: The IBM bond will most likely default in recessions. So, the CDS seller has to pay up in bad times — when the rest of its investments are likely doing poorly and so making this payment is particularly painful.
As a result, the CDS seller charges a premium for this risk. This is similar to why stocks offer a much higher expected return than bonds — to compensate for timevarying credit risk and liquidity premia in bond and cds markets fact that stocks perform poorly in recessions.
There may be few sellers of CDS, and many buyers. Thus, the sellers can charge a premium. They thus consider two types of predictors for the ratio: Firm-Specific Predictors to open the black box of firm fixed effects. These include Refined Ratings. The authors find that refined ratings exhibit much greater time-series variation than raw ratings.
This is indicative of clientele effects: Thus, high-yield bonds end up in the hands of few investors, who bear a lot of risk and thus have a high demand for CDS protection Temporary Clientele Effects.
These are measured by recent credit upgrades, downgrades, and changes in investment grade vs. A recent downgrade leads to an increase in scaled credit risk premia, for similar intuition to the prior point. A downgrade may lead to some investors fleeing from a bond, and new investors being slow to move in and purchase it.
A higher level of implied volatility is associated with higher scaled credit risk premia, since default is likelier. Scaled credit risk premia are higher in financial services, technology, telecoms and utilities, and lower in healthcare.
Macroeconomic Predictors to open the black box of month fixed effects. These include Five-Year Treasury Rate. A lower interest rate is associated with higher scaled credit risk premia, consistent with prior literature University of Michigan Consumer Sentiment Index.
The authors proxy for this using the aggregate amount of CDS outstanding. Iconic One Theme Powered by Wordpress.
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