Credit Risk Premium Research Articles

Desirable Portfolios in Fixed Income Markets: Application to Credit Risk Premiums

An arbitrage portfolio provides a cash flow that can never be negative at zero cost. We define the weaker concept of a “desirable portfolio” delivering cash flows with negative risk at zero cost. Although these are not completely risk-free investments and subject to the risk measure used, they can provide attractive investment opportunities for investors. We investigate in detail the theoretical aspects of this portfolio selection procedure and the existence of such opportunities in fixed income markets. Then, we present two applications of the theory: one in analyzing market integration problem and the other in gauging the credit quality of defaultable bonds in a portfolio. We also discuss the model calibration and provide some numerical illustrations.

Corporate Credit Risk Premia

We measure credit risk premia - prices for bearing corporate default risk in excess of expected default losses - using Markit CDS and Moody’s Analytics EDF data. We find dramatic variation over time in credit risk premia, with peaks in 2002, during the global financial crisis of 2008-09, and in the second half of 2011. Even after normalizing these premia by expected default losses, median credit risk premia fluctuate over time by more than a factor of ten. Credit risk premia comove with macroeconomic indicators, even after controlling for variation in expected default losses, with higher premia per unit of expected loss during times of market-wide distress. Countercyclical variation of premia-to-expected-loss ratios is more pronounced for investment-grade issuers than for high-yield issuers.

Credit Risk Premia and Intermediaries Leverage

Credit Risk Premia and Intermediaries Leverage

Positive Liquidity Spillovers from Sovereign Bond-Backed Securities

This paper contributes to the debate concerning the benefits and disadvantages of introducing a European Sovereign Bond-Backed Securitisation (SBBS) to address the need for a common safe asset that would break destabilising bank-sovereign linkages. The analysis focuses on assessing the effectiveness of hedges incurred while making markets in individual euro area sovereign bonds by taking offsetting positions in one or more of the SBBS tranches. Tranche yields are estimated using a simulation approach. This involves the generation of sovereign defaults and allocation of the combined credit risk premium of all the sovereigns, at the end of each day, to the SBBS tranches according to the seniority of claims under the proposed securitisation. Optimal hedging with SBBS is found to reduce risk exposures substantially in normal market conditions. In volatile conditions, hedging is not very effective but leaves dealers exposed to mostly idiosyncratic risks. These remaining risks largely disappear if dealers are diversified in providing liquidity across country-specific secondary markets and SBBS tranches. Hedging each of the long positions in a portfolio of individual sovereigns results in a risk exposure as low as that borne by holding the safest individual sovereign bond (the Bund).

Assessing sovereign default risk: A bottom-up approach

This study assesses sovereign default risk of individual U.S. states utilizing information about default risk at the company level. We link integrated risk factors of the private sector to the overall sovereign risk of state governments in conjunction with additional financial variables. Using data on Moody’s KMV expected default frequencies (EDFs) on corporate default risk, we derive credit risk indicators for different industries. Building on these measures, we then develop state level credit risk indicators encompassing industry compositions to explain the behaviour of credit default swap (CDS) spreads for individual states. We find that market-based measures of private sector credit risk are strongly associated with subsequent shifts in sovereign credit risk premiums, as measured by CDS spreads. The developed credit risk indicators are highly significant in forecasting sovereign CDS spreads at weekly and monthly sampling frequencies. Overall, our findings suggest a strong predictive link between market expectations of private sector credit quality and expectations of sovereign credit quality - a connection that is not directly discernible from scoring models.

Is There a Distress Risk Anomaly? Pricing of Systematic Default Risk in the Cross-section of Equity Returns*

The standard measures of distress risk ignore the fact that firm defaults are correlated and that some defaults are more likely to occur in bad times. The paper uses risk premium computed from corporate credit spreads to measure a firm's exposure to systematic variation in default risk. Unlike previously used measures that proxy for a firm's physical probability of default, credit spreads proxy for a risk-adjusted default probability and thereby explicitly account for the non-diversifiable component of distress risk. In contrast to prior findings in the literature, the authors find that stocks that have higher credit risk premia, that is stocks with higher systematic default risk exposures, have higher expected equity returns. Consistent with structural models of default, they show that the premium to a high-minus-low systematic default risk hedge portfolio is largely explained by the market factor. The authors confirm the robustness of these results by using an alternative systematic default risk factor for firms that do not have bonds outstanding. The results show no evidence of firms with high systematic default risk exposure delivering anomalously low returns.

Economic and Financial Determinants of Credit Risk Premiums in the Sovereign CDS Market*

We specify and estimate no-arbitrage models for sovereign CDS contracts by assuming that the country’s default intensity depends on observable economic and …nancial indicators. We estimate these models using a sample of twenty-eight countries, three CDS maturities, and over a decade of daily data. The models provide a good …t. The impact of the economic and …nancial variables on spreads is consistent with economic intuition. Spreads increase as a function of stock market and exchange rate volatility, but decrease as a function of interest rates and stock market returns. The magnitudes of these impacts vary substantially across countries and over time. Estimated risk premiums are also highly time-varying and peak during the 2008 …nancial crisis for nearly all countries. For European countries, the risk premiums are also high during the Eurozone debt crisis. In periods of market stress and high CDS spreads, the increase in market risk premiums is even larger than the increase in default probabilities. The cross-sectional variation in risk premiums across countries is high, also in non-crisis periods.

Corporate Credit Risk Premia

We measure credit risk premia - prices for bearing corporate default risk in excess of expected default losses - using Markit CDS and Moody’s Analytics EDF data. We find dramatic variation over time in credit risk premia, with peaks in 2002, during the global financial crisis of 2008-09, and in the second half of 2011. Even after normalizing these premia by expected default losses, median credit risk premia fluctuate over time by more than a factor of ten. Credit risk premia comove with macroeconomic indicators, even after controlling for variation in expected default losses, with higher premia per unit of expected loss during times of market-wide distress. Countercyclical variation of premia-to-expected-loss ratios is more pronounced for investment-grade issuers than for high-yield issuers.

The Transmission Channels of Quantitative Easing: Evidence from the Cross-Section of Bond Prices and Issuance

After the announcement of the European Central Bank’s corporate quantitative easing program, non-financial corporations timed the bond market by shifting their issuance toward bonds eligible for the program. However, issuers of eligible bonds did not increase total issuance compared to other issuers; nor did they experience different economic outcomes. Instead, the announcement produced substantial spillover effects on risk premia. Credit risk premia declined, both in the corporate bond market and in the default swap market, whereas the valuation of eligible bonds did not change relative to comparable ineligible bonds. Firms took advantage of reduced risk premia by issuing riskier bond types. Using a novel and comprehensive dataset of corporate bonds in the euro area, we document how firms substituted across bond characteristics, and we find evidence of their intention to time the market. Our model indicates corporate market timing is instrumental in allowing quantitative easing to produce spillover effects.

The Credit Risk Premium

Despite theoretical and intuitive reasons for a credit risk premium, past research has found little supporting empirical evidence. This is primarily attributable to biases in computing credit excess returns, which improperly account for term risk. Using data spanning 80 years in the United States and nearly 20 years in Europe, the authors find strong evidence of a credit risk premium after correctly adjusting for term risk. The credit risk premium is not spanned by other known risk premia, and it exhibits time variation related to economic growth and aggregate default rates. These results have important implications for asset pricing and investment decisions.

Government Debt and Risk Premia

I document that government debt is related to risk premia in various asset markets: (i) the debt-to-GDP ratio positively predicts excess stock returns with out-of-sample R 2 up to 30% at a five-year horizon, outperforming many popular predictors; (ii) the debt-to-GDP ratio is positively correlated with credit risk premia in both corporate bond excess returns and yield spreads; (iii) higher debt-to-GDP ratio is associated with lower real risk-free rates, (iv) higher debt-to-GDP ratio corresponds to lower average expected returns on government debt; (v) debt-to-GDP ratio positively comoves with fiscal policy uncertainty. I rationalize these empirical findings in a general equilibrium model featuring recursive preferences, endogenous growth, distortionary taxation, and time-varying fiscal uncertainty. In the model, the tax risk premium is sizable and its time variation is driven by fiscal uncertainty. Furthermore, the model generates an endogenous relationship between the debt-to-GDP ratio and fiscal uncertainty. Fiscal uncertainty increases debt valuation through lower government discount rate. This mechanism is reinforced as higher debt conversely raises uncertainty because of future fiscal consolidations.

Arbitrage Costs and the Persistent Non-Zero CDS-Bond Basis: Evidence from Intraday Euro Area Sovereign Debt Markets

We find evidence that in the market for euro area sovereign credit risk, arbitrageurs engage in basis trades between credit default swap (CDS) and bond markets only when the CDS-bond basis exceeds a certain threshold. This threshold effect is likely to reflect costs that arbitrageurs face when implementing trading strategies, including transaction costs and costs associated with committing balance sheet space for such trades. Using a threshold vector error correction model, we endogenously estimate these unknown trading costs for basis trades in the market for euro area sovereign debt. During the euro sovereign credit crisis, we find very high transaction costs of around 190 basis points, compared to around 80 basis points before the crisis. Moreover, we find that once the threshold has been exceeded, the basis reverts back towards its long-run equilibrium substantially faster than when the basis is below the threshold. Our findings help explain the persistent non-zero basis or spread between credit risk premia in CDS and sovereign bond markets and suggest that the significant increase in the basis during the crisis was due to sharply higher costs facing arbitrageurs in the market, as well as compensation for increased risk that the trade would go against them in the short run.

This time is different: Causes and consequences of British banking instability over the long run

This paper addresses three questions: (1) How severe were the episodes of banking instability experienced by the UK over the past two centuries? (2) What have been the macroeconomic indicators of UK banking instability? and (3) What have been the consequences of UK banking instability for the cost of credit? Using a unique dataset of bank share prices from 1830 to 2010 to assess the stability of the UK banking system, we find that banking instability has grown more severe since the 1970s. We also find that interest rates, inflation, lending growth, and equity prices are consistent macroeconomic indicators of UK banking instability over the long run. Furthermore, utilising a unique dataset of corporate-bond yields for the period 1860 to 2010, we find that there is a significant long-run relationship between banking instability and the credit-risk premium faced by businesses.

An International Examination of the Role of Default and Liquidity Risks in the Interbank Market.

We estimate a no-arbitrage model of the term structure of international interbank spreads, and attempt to disentangle credit and liquidity risk premium in the interbank market. We study the consistency of the spreads’ movements across major currencies and assess the effectiveness of monetary policy actions on the deterioration of credit and liquidity risks. We find that at the core of the financial crisis, the interbank spread is clearly driven by liquidity risk. The effect is stronger in the US market, where liquidity pressures were severe. Our analysis suggests that the establishment of the unconventional policy programs, led to the deterioration of liquidity risk in the interbank market. Furthermore, the policy of major Central banks to substantially cut interest rates, kept credit pressures at low levels. By early 2009, the dominant driver of the spread is credit risk. This effect is stronger in the Euro and UK markets, due to the escalation of the European sovereign debt crisis. This is not the case for the Japanese market, which experienced remarkably low credit pressures during the core of the crisis. Moreover, we decompose the spread into an expectation hypothesis component and a time-varying risk premia component and find that the hypothesis of constant risk premia is rejected.

The relationship between risk-neutral and actual default probabilities: the credit risk premium

ABSTRACTThe study investigates empirically the relationship between the risk-neutral measure Q and the real-world measure P. We study the ratio between the risk-neutral and actual default intensities, which we call the coverage ratio or the relative credit risk premium. Actual default intensities are derived from rating agencies annual transition matrices, while risk-neutral default intensities are bootstrapped from CDS quotes of European corporates. We quantify the average risk premium and its changes over time. Compared to related literature, special attention is given to the effects of the recent financial and European sovereign crises. We find that average credit risk premia rose substantially and that post-crisis levels are still higher than those observed before the financial crisis. This observation is especially true for high-quality debt and if it persists, it will have an impact on corporates funding costs. The quantification and revision of risk premia contributes to the discussion of the credit spread puzzle and could give extra insights in valuation models that start from real-world estimates. Our work is furthermore important in the context of state aid assessment. The real economic value (REV) methodology, applied by the European Commission to evaluate impaired portfolios, is based on a long-term average risk premium.

Measuring Financial Fragmentation in the Euro Area Corporate Bond Market

This paper analyses the determinants of euro area non-financial corporate bonds over the last decade. We decompose the spread between the yield of German, French, Italian and Spanish corporate bonds vis-a-vis the German Bund of similar maturity into country, credit and duration risk premia components via dummy regressions. We highlight three main findings. First, the initial phase of the financial crisis (2008-2009) caused an overall increase in credit risk premia. Since the beginning of 2013 credit risk premia are back to levels comparable to those preceding the financial crisis. Second, at the height of the euro area sovereign crisis (2011-2012), high credit risk premia were accompanied by strong and persistent signs of market fragmentation in Italy and Spain (but not in France). This fragmentation has reached its peak in the second half of 2012 and has started to recede only after the announcement of the OMT. Third, we provide a simple measure of financial integration across the big 4 member states of the euro area.

Government-Backed Mortgage Insurance, Financial Crisis, and the Recovery from the Great Recession

The Great Recession provides an opportunity to test the proposition that government mortgage insurance programs mitigated the effects of the financial crisis and enhanced the economic recovery from 2009 to 2014. We find that government-sponsored mortgage insurance programs have been responsible for better economic outcomes in counties that participated heavily in these programs. In particular, counties with high levels of participation from government-sponsored enterprises and the Federal Housing Authority had relatively lower unemployment rates, higher home sales, higher home prices, lower mortgage delinquency rates, and less foreclosure activity, both in 2009 (soon after the peak of the financial crisis) and in 2014 (six years after the crisis) than did counties with lower levels of participation. The persistence of better outcomes in counties with heavy participation in federal government programs is consistent with a view that lower government liquidity premiums, lower government credit-risk premiums, and looser government mortgage-underwriting standards yield higher private-sector economic activity after a financial crisis.

Term Structure of Hedging Premia and Basis Arbitrages in Synthetic-Cash Credit Market

This paper investigates the price formation of credit risk premia across European sovereign countries. A metric of such premia is retrieved under the statistical measure using bootstrap techniques on hedging portfolios. This latter is retrieved in the cash-synthetic market by means of comparison to standard credit spreads vis-a-vis Germany. Price discovery is then analyzed in a VECM setting by means of lead-lag analysis. Discrepancies between the two credit metrics induces the CDS-bond basis, here defined as the spread of a benchmark rate on target hedged position. The basis is explained across a panel of four core and four non-core countries using idyosincratic and common regressors. The retrieved unobserved fixed effects are then used as a metric for liquidity premia.

What can increase the default risk in local governments?

Concern has been expressed by international organisations and in previous studies about the financial situation of local governments, and the question of debt has been identified as a crucial element in efforts to overcome the current financial crisis. However, the variables that can affect the financial soundness of these governments have not been sufficiently studied, despite their direct relation to the credit risk premium. In this article, we aim to identify risk factors for default by local governments, and provide useful information to municipal financial managers. We conducted an empirical study of 148 Spanish municipalities and analysed data from four years, applying a random effects logistic regression model. Our findings reveal that a lower population density, less dependent population, falling levels of per capita income and the presence of progressive local government are all risk factors for default by local governments. Furthermore, our findings indicate that the general financing structure variable and debt composition and maturity variable do influence the risk of default by local governments. Points for practitioners The findings of this article can provide useful information for managers and politicians responsible for the financial management of local governments, in particular, by enabling them to better understand the risk premiums assigned by banks. Specifically, by identifying the risk factors for default, this article highlights the warning signs of this risk, so that suitable arguments may be expressed in negotiating loan repayment schedules and interest rates, and in designing financial viability and restructuring plans.

Loan price modelling for local governments using risk premium analysis

Previous studies have highlighted the question of government loan interest as one of great current importance. Government borrowing levels are high, and reducing interest payments would generate savings to meet other spending needs and/or to lower taxation, thus supporting the sustainability of public finances. However, no previous study has presented a method for a local government to calculate its own credit risk and thus be in a position to negotiate lower interest rates on its borrowing. This article defines a financial model that enables local governments to estimate the interest rate payable on a bank loan, based on their credit risk premium, in accordance with the Basel II rules and the findings of our empirical study of large local governments.