Dissecting Corporate Bond and CDS Spreads

Abstract

In this article, the authors propose a new method to estimate the components of corporate bond and CDS spreads. They 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 they jointly estimate parameters of both models from the pooled data. By formulating default intensity as a common factor in the prices of the CDS and reference bonds, the authors are able to identify the default and nondefault components of yield spreads more precisely. They find that, on average, the liquidity premium accounts for about 20–25% of corporate yield spreads across ratings and the size of the liquidity premium increases as the rating decreases. Furthermore, they find that the CDS spread contains a nontrivial nondefault component. Ignoring this component in the CDS spread thus results in a serious bias in the estimate of spread components when using the CDS information to aid in decomposition of corporate yield spreads.