Credit Risk Premium Research Articles

Alternatives to LIBOR

Evidence of extensive fraud in LIBOR submissions has fueled international calls for reform. A common theme is that the current rate setting process, in addition to being subject to manipulation, relies on conjecture as to rates that might prevail in markets that can often be illiquid, and should be replaced with a process that relies more directly on actual transactions. There are no perfect substitutes for LIBOR. Overnight index swap rates and repo rates, the most attractive alternatives to LIBOR, do not incorporate the same counterparty credit risk or term premiums. Repo rates also reflect the risks of underlying collateral, which can be inappropriate for certain market participants. Liquidity in these alternatives is also concentrated in shorter maturities. These differences make it difficult for LIBOR alternatives to fully replace LIBOR in all instances.The challenge of finding a LIBOR substitute can be reframed along three dimensions. With regard to existing contracts, the challenge may be to reform the current version of LIBOR so it better reflects legitimate market expectations while being less susceptible to self-serving panel bank manipulation. With respect to new contracts, parties can look to a wide variety of LIBOR alternatives to select a substitute. Put another way, it makes little sense, on a prospective basis, to require a single substitute for LIBOR when the market may rationally prefer any of several viable alternatives. And, once new metrics have been established in the market for new contracts, renegotiating existing contracts to substitute a new metric for the current LIBOR, or improved version of LIBOR, may be easier.Identifying a single, best substitute for LIBOR may thus be a fool’s errand. Creating an environment in which many different alternatives can legitimately co-exist may be a preferred strategy.

Sovereign Bond Risk Premiums

Credit risk has become an important factor driving government bond returns. We therefore introduce an asset pricing model which exploits information contained in both forward interest rates and forward CDS spreads. Our empirical analysis covers euro-zone countries with German government bonds as credit risk-free assets. We construct a market factor from the first three principal components of the German forward curve as well as a common and a country-specific credit factor from the principal components of the forward CDS curves. We find that predictability of risk premiums of sovereign euro-zone bonds improves substantially if the market factor is augmented by a common and an orthogonal country-specific credit factor. While the common credit factor is significant for most countries in the sample, the country-specific factor is significant mainly for peripheral euro-zone countries. Finally, we find that during the current crisis period, market and credit risk premiums of government bonds are negative over long subintervals, a finding that we attribute to the presence of financial repression in euro-zone countries.

Alternatives to Libor

Evidence of extensive fraud in LIBOR submissions has fueled international calls for reform. A common theme is that the current rate setting process, in addition to being subject to manipulation, relies on conjecture as to rates that might prevail in markets that can often be illiquid, and should be replaced with a process that relies more directly on actual transactions. There are no perfect substitutes for LIBOR. Overnight index swap rates and repo rates, the most attractive alternatives to LIBOR, do not incorporate the same counterparty credit risk or term premiums. Repo rates also reflect the risks of underlying collateral, which can be inappropriate for certain market participants. Liquidity in these alternatives is also concentrated in shorter maturities. These differences make it difficult for LIBOR alternatives to fully replace LIBOR in all instances.The challenge of finding a LIBOR substitute can be reframed along three dimensions. With regard to existing contracts, the challenge may be to reform the current version of LIBOR so it better reflects legitimate market expectations while being less susceptible to self-serving panel bank manipulation. With respect to new contracts, parties can look to a wide variety of LIBOR alternatives to select a substitute. Put another way, it makes little sense, on a prospective basis, to require a single substitute for LIBOR when the market may rationally prefer any of several viable alternatives. And, once new metrics have been established in the market for new contracts, renegotiating existing contracts to substitute a new metric for the current LIBOR, or improved version of LIBOR, may be easier.Identifying a single, best substitute for LIBOR may thus be a fool’s errand. Creating an environment in which many different alternatives can legitimately co-exist may be a preferred strategy.

Analyzing the role of mutual guarantee societies on bank capital requirements for small and medium-sized enterprises

This paper analyzes the impact of the guarantee provided by mutual guarantee societies (MGSs) on the risk premium that banks should charge for small- and medium-sized enterprise (SME) loans under the new Basel Capital Accords (Basel II and III). We also examine whether the foreseeable decrease in the theoretical credit risk premium would be compensated by the cost of the MGS guarantee. To do so, we develop a rating system for SMEs that uses a large sample of Spanish firms over the period from 2005 to 2009. We find that the final effect of the guarantee on the SME risk premium depends on the values taken by the credit variables of the MGS (essentially, the probability of default).

Corporate Bond Risk Premia

This paper investigates the holding period risk premia of U.S. corporate and Treasury bonds. Using excess return regressions, two priced risk factors are derived from yield and macroeconomic data: a priced term risk factor and a priced credit risk factor explain half of the variation in one-year corporate and Treasury excess returns. The information of the term risk factor is not represented by major yield characteristics but is a hidden risk factor whereas the credit risk factor is not hidden. The term risk premium is earned primarily for exposure to inflation and the yield level and the credit risk premium is earned for an exposure to real growth and the credit spread level. The regression results are usefull for the specification of the market prices of risk in affine credit term structure models: The two-factor representation of the risk premium suggests a rank restriction on the market prices of risk and an additional pricing factor to capture the hidden property of term risk.

What is a Prime Bank? A Euribor – OIS Spread Perspective

Since the outbreak of the financial crisis in 2007, the level and volatility of Euribor – OIS differentials have increased significantly. According to the extant literature, this variability is mainly explained by credit and liquidity risk premia. I provide evidence that part of the variability might also be explained by ambiguity in the phrasing of the Euribor survey. Participants in the survey are asked at what rate they believe interbank funds to be exchanged between prime banks; given the lack of a clear definition of the concept of prime bank, this question might leave room for subjective judgment. In particular, I find evidence that some variability of Euribor rates might be explained by changes in the survey participants' perception of what a prime bank is. This adds to the difficulties already encountered by previous studies in exactly identifying and measuring the determinants of Euribor rates. I argue that these difficulties are at odds with the clarity, simplicity and replicability that should be required of a widely utilized financial benchmark.

How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk?

We show that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturities, and that it accounts for a much higher fraction of yield spreads for high-yield bonds. This conclusion is shown to be robust across a wide class of structural models. We obtain such results by calibrating each of the models to be consistent with data on the historical default loss experience and equity risk premia, and demonstrating that different models predict similar credit risk premia under empirically reasonable parameter choices.

Margin-Based Asset Pricing and the Determinants of the CDS Basis

The Credit Default Swap (CDS) basis was significantly negative during the 2007-2009 financial crisis, which was considered an anomaly. Using single-name CDS data, we find that the CDS basis decreases as the funding costs, credit risk premium, and market illiquidity increase. Further, cross-sectional results show that the sensitivities of the CDS basis to funding costs, credit risk premium, and market illiquidity are priced, even after controlling for the individual bond liquidity and other firm characteristics. The results are consistent with the margin-based asset pricing theories that the difference in margin requirements on two otherwise identical securities gives rise to bases.

The cost of bank liquidity

Many banks are under regulatory pressure from Basel III to improve liquidity by investing in more short-term, low-risk securities and to fund assets by more long-term, stable sources of debt. The relationship between short-term and long-term interest rates is known as the term structure of interest rates long evaluated by financial economists. This article empirically demonstrates the importance of a liquidity premium and a credit risk premium within the term structure and notes the financial consequence of these incremental costs on banks trying to enhance their liquidity coverage ratio or their net stable funding ratio. Liquidity has a cost that will reduce bank profits via a lower net interest spread. If bank liquidity is sufficient to withstand subsequent periods of market stress, the regulatory plan will reduce public expenditures often associated with bank failure.

Credit risk dynamics in response to changes in the federal funds target: The implication for firm short-term debt

The recent credit crisis has raised a number of interesting questions regarding the role of the Federal Reserve Bank and the effectiveness of its expected and unexpected interventions in financial markets, especially during the crisis, given its mandate. This paper reviews and evaluates the impact of expected and unexpected changes in the federal funds rate target on credit risk premia. The paper's main innovation is the use of an ACH-VAR (autoregressive conditional hazard VAR) model to generate the Fed's expected and unexpected monetary policy shocks which are then used to determine the effects of a Federal Reserve policy change on counterparty credit risk and more importantly short-term firm debt financing. The findings answer a longstanding question sought by researchers on the effect of policy makers' announcements on firm debt financing. The results clearly show that the Federal Reserve influences short-term debt financing through the credit channel for both expansionary and contractionary monetary policies. In particular, we find that the growth in counterparty risk appears less responsive to anticipated responses in the Fed funds rate that fail to materialize than to an unanticipated increase in the federal funds rate. Finally, we also document that the results appear to validate the Feds interventions in financial markets to stem counterparty risk and to make liquidity more readily available to firms.

Boom-Bust Cycles, Imbalances and Discipline in Europe

The fallout from the 2008 financial crisis has been particularly acute in the euro area Member States of the south-western rim and in the new EU Member States, due to their previously accumulated macroeconomic and financial imbalances. The perception that the euro environment provided a solid shield against economic instability shaped the incentives, expectations and actions of agents, markets and policymakers. This, in turn, eroded discipline at all levels: EU-wide surveillance, domestic policies and markets. The empirical analysis of this paper, focused on market discipline, shows that before the crisis credit risk premia neglected fiscal imbalances and hardly reflected external or financial imbalances, in particular in advanced economies. This result is partly explained by the masking effect of the expansionary phase on underlying imbalances. The crisis has shattered the perception of the euro as a safe haven for economic stability, where imbalances do not matter. Moreover, the severity of the crisis has uncovered the fragilities of the institutional framework underpinning the euro and is leading to its reinforcement by means of stronger economic governance and surveillance. Going forward, however, a further two factors may exert a greater impact on the future discipline and stability of the European economies: i) more stringent financing conditions by markets, contingent on fundamentals, although there are doubts on the persistence of this discipline in future expansionary phases; and, above all ii) domestic policymaking conduct that is consistent with the constraints that EMU entails. These three forces could settle the European integration process and EMU on a more solid footing, although the jury is still out.

Rationalization of investment preference criteria

The majority of risk adjusted performance measures (RAPM) currently in use – e.g., Treynor ratio, (?/?)) ratio, Omega index, RoVaR, ‘coherent’ preference criteria, etc. – are incompat- ible with any sensible utility function and would be best avoided. We argue instead for the assessment of a maximum certainty equivalent excess return (CER*) criterion, or equivalent criteria, adapted to investment circumstances: alternative investments, return forecasts, and risk attitude. We explain the assessment of CER*s and give three applications: performance comparisons among traditional and alternative funds, optimal design of structured products, and explanation of the credit risk premium puzzle.

The Credit Risk Premium: Should Investors Overweight Credit, When, and By How Much?

The Credit Risk Premium: Should Investors Overweight Credit, When, and By How Much?

The Credit Risk Premium and Return Predictability in High Yield Bonds

I demonstrate that much of the time series variation in the credit spread on high yield bonds is attributable to changes in the “credit risk premium” rather than changes in expected default losses. The credit risk premium is the expected excess return investors earn from bearing default risk on high yield bonds. I find that the credit risk premium on high yield bonds averages about 2.4 percent per year, accounts for 43 percent of high yield credit spreads, on average, and predicts excess returns on high yield bonds. I also find that the excess returns on lower rated credits (B and CCC, relative to BB) are more sensitive to variation in the credit risk premium. The credit risk premium increases with the conditional volatility of default losses and decreases with aggregate consumption growth. The evidence suggests that conventional measures of economic risk are able to explain the sizeable increase in credit spreads in the fall of 2008.

Inferring Default Probabilities from Credit Spreads

Default probabilities (PDs) for risky obligors are derived from market spreads and spread volatilities. The method assumes that 1) credit spreads, on average, are linear functions of spread volatility and that 2) investors require the same spread compensation per unit of spread volatility regardless of its source. Credit spreads are decomposed into two parts: compensation for default and compensation for spread volatility. An analysis of the credit risk premium is described as a precursor to estimating default probabilities from market data. Finally, market-implied PDs are used to assess risk and relative value of global sovereign issuers of external debt.

A Note on the Credit Risk Component of Yields on Irish Sovereign Bonds Issued in Foreign Currencies

In this note we provide new evidence regarding the size and dynamics of the credit risk premium on Irish Sovereign bonds during the 1980s and early 1990s. This is based on foreign issues of Irish bonds. Our results indicate that there was a small but significant risk premium related to expected future fiscal instability. We use this new evidence from the past to assess more recent developments.

What drives the cost of US dollar bond funding for banks?

This paper decomposes issue spreads on US dollar-denominated bonds issued by LIBOR panel banks into credit risk and liquidity premium components. We attribute the recent increase in issue spreads to the investor perception that banks are less creditworthy than in the past. Although the behaviour of the credit risk component is well-explained by a structural model of default, this mechanism is nullified by the introduction of government guarantees. The behaviour of the liquidity premium component is partially explained by the bid/ask spread in the secondary market and issue size. Government guarantees also reduce the liquidity component of the issue spread.

Liquidity and Credit Risk Premia in Government Bond Yields

This paper quantifies liquidity and credit premia in German and French government bond yields. For this purpose, we estimate term structures of government-guaranteed agency bonds and exploit the fact that any difference in their yields vis-`a-vis government bonds can be attributed to differences in liquidity premia. Adding the information on risk-free rates, we obtain model-free and model-based gauges of sovereign credit premia, which are an important alternative to the information based on CDS markets. The results allow us to quantify the price impact of so-called JEL Classification: E44, G12, G01

Market response to policy initiatives during the global financial crisis

This paper examines the impact of macroeconomic and financial sector policy announcements in the United States, the United Kingdom, the euro area, and Japan on interbank credit and liquidity risk premia during the recent crisis. Overall, policy interventions were associated with a reduction in interbank risk premia, most significantly for recapitalization programs. By contrast, decisions to bail out individual banks in an ad hoc manner or let them fail were accompanied by a significant rise in interbank risk premia. Most policy announcements had international spillovers. These results are broadly robust to using alternative measures of financial distress and varying the size of the event window.

The Credit Risk Premium: Should Investors Overweight Credit, When, and By How Much?

The authors revisit the case for maintaining a strategic overweight to corporate bonds in fixed income portfolios based on the notion of the credit risk premium. Using a series of excess returns to investment-grade corporate bonds going back to 1926, the authors find evidence of a positive risk premium of corporate bonds over Treasuries. However, investors who rely on a passive structural overweight should be aware of the substantial additional tracking error and the long payoff periods required. Second, they examine the behavior of credit excess returns through many cycles, using the OECD Composite Leading Index to divide economic activity into four re-occurring phases. At the margin, the results are useful in guiding portfolio managers and asset owners in their tactical decisions with regard to the magnitude of the credit tilt. <b>TOPICS:</b>Fixed-income portfolio management, mutual funds/passive investing/indexing, analysis of individual factors/risk premia