Abstract
Measures of corporate credit risk incorporate compensation for unpredictable future changes in the credit environment and compensation for expected default losses. Since the launch of purchases of government securities and corporate securities by the European Central Bank, it has been discussed whether the observed reduction in corporate credit risk was due to the decrease in risk aversion favored by the monetary easing or by expectations of lower losses due to corporate defaults. This work introduces a new methodology to break down the factors that drive corporate credit risk, namely the premium linked to cyclical and monetary conditions and that linked to the restructuring of the companies. Untangling these two components makes it possible to quantify the drivers of excess returns in the corporate bond market.
Highlights
Corporate bond spreads are carefully monitored by central banks as they influence the transmission of monetary policy decisions to the real economy, determining their effectiveness
Our median jump-at-default estimate is 11 basis points, that is in line with the existing literature (Diaz et al (2013) estimate a median jump-at-default of 13 basis points). This result indicates that the default event itself entails a risk premium and that this premium increases during the times of stress, which agrees with the intuition on the jump-at-default risk premium
The purpose of this paper is to investigate whether the reduction observed in corporate bond spreads after the launch of the program can be attributed more to a reduction in expected losses or to a reduction in risk premia, and in particular to the compensation requested by investors for the changes in the the credit environment associated with business and macro conditions and the compensation for the risk associated with a jump in the price of the bond in the event of default
Summary
Corporate bond spreads are carefully monitored by central banks as they influence the transmission of monetary policy decisions to the real economy, determining their effectiveness. The main objective of our analysis is to understand whether the significant reduction in corporate bond spreads observed since the launch of the CSPP can be attributed more to the capacity of unconventional measures to reduce expected losses by improving investors’ expectations regarding the economic and financial conditions of issuers or to the fact that expansionary monetary policy measures tend to increase investors’ risk appetite and, to compress risk premia. It is well known that these two different aspects are possible and desirable effects of unconventional measures and both are reflected in corporate bond spreads as compensation for the expected losses and the bond risk premium required by investors, respectively.. Empirical literature suggests that CDS spreads are better measures of default risk than bond spreads for a variety of reasons. Mainly because: the corporate CDS market is more liquid than the corresponding bond market; in practice it is difficult to construct bond spreads (for example in terms of maturity matching); it is known that the CDS market plays a leading role in the price discovery process.
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