Dissecting Corporate Bond and CDS Spreads

Abstract

In this paper, we propose an alternative approach to estimate the components of corporate bond and CDS spreads. We develop a CDS pricing model with default and nondefault factors, and a corporate bond pricing model with default, tax and liquidity factors using the reduced-form approach, and jointly estimate parameters of both models from pooled data. By formulating default intensity as a common factor in the prices of the CDS and reference bonds, we are able to identify the liquidity and other components of yield spreads more precisely. We find that on average the liquidity premium accounts for about 23% of the corporate yield spread and the size of the liquidity premium increases as the rating decreases. Furthermore, the CDS spread contains a significant nondefault component. Results show that ignoring the nondefault component in the CDS premium results in biased estimates of corporate yield spread components when using the CDS information to aid in decomposition of yield spreads.