The Effects of Default Correlation on Corporate Bond Credit Spreads

Abstract

I analyse the relationship between systematic default correlation and corporate bond credit spreads and show that credit spreads are positively related to CDO market implied default correlation. This holds using either a model implied measure of default correlation or the spread between a CDO's equity and super-senior tranches and after controlling for the risk-free term structure of interest rates, equity market returns and volatility, and firm and bond characteristics. I show that a one basis point decrease in the CDO tranche spread-of-spreads is associated with a 0.79 basis point increase in 5-year credit spreads and a 0.94 basis point increase in 10-year credit spreads for monthly data spanning January~2004 to September~2008. Principal component analysis performed on the regression residuals indicates that the model specification is not missing a systematic factor.