Dynamics Of Credit Spreads Research Articles

Emerging Bond Markets in Asia: Credit Spread Dynamics

Emerging Bond Markets in Asia: Credit Spread Dynamics

Emerging Bond Markets in Asia: Credit Spread Dynamics

Emerging Bond Markets in Asia: Credit Spread Dynamics

Emerging Bond Markets in Asia: Credit Spread Dynamics

We present a comprehensive analysis of the credit spread determinants in five Asian bond markets over a sample period of 10 years, from January 2010 to December 2019. Consistent with the western literature, we find that the structural models are broadly valid even in emerging countries with developing bond markets. Empirical results unveiled that bond-specific liquidity is the most important driver that reduces the credit spread, followed by the slope of the term structure and industrial growth in the economy. In Emerging Asia, inflation is the key driver that aggravates credit spread for business firms, followed by financial market volatility. Cross-country data reveals that the Chinese corporate bond market is the largest in Asia. Indian markets offer higher yield rates, while credit spread is noted to be highest in China. The empirical findings of our study would provide important insights for the policy makers while developing the most sought-after liquid bond markets. Effective liquid bond markets would reduce the cost of capital for firms and price credit risks efficiently.

Affine Modeling of Credit Risk, Pricing of Credit Events, and Contagion

We propose a discrete-time affine pricing model that simultaneously allows for (i) the presence of systemic entities by departing from the no-jump condition on the factors’ conditional distribution, (ii) contagion effects, and (iii) the pricing of credit events. Our affine framework delivers explicit pricing formulas for default-sensitive securities such as bonds and credit default swaps (CDSs). We estimate a euro-area multicountry version of the model and address economic questions related to the pricing of sovereign credit risk. We find that both frailty (common factors) and contagion phenomena are important to account for the joint dynamics of credit spreads. Our results also provide evidence of credit-event pricing, which is at the source of substantial credit risk premiums, even for short maturities. Finally, we extract measures of depreciation-at-default from CDSs denominated in different currencies. This paper was accepted by Kay Giesecke, finance.

Interest Rates and Credit Spread Dynamics

This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. These results imply a dynamic process for credit spreads that is not captured in existing models for pricing corporate bonds or measuring their interest rate sensitivity.

THE IMPACT OF LEARNING ON BUSINESS CYCLE FLUCTUATIONS IN THE CONSUMER UNSECURED CREDIT MARKET

We document that the credit spread on consumer unsecured debt exhibits a persistent, hump-shaped response to an increase in the charge-off rate. This stylized fact poses a significant challenge for a standard model of consumer default in which lenders have rational expectations and, therefore, the credit spread continuously adjusts to reflect the true default incentives of each borrower. In an effort to explain this feature of the data, we construct a model of consumer default with countercyclical income risk in which lenders learn about default risk over time by observing the history of repayment decisions, as is the case in practice. In addition to matching credit spread dynamics, allowing lenders to learn about default risk substantially improves the model’s ability to generate realistic business cycle fluctuations in the consumer unsecured credit market and match the cross-sectional distribution of unsecured debt and dispersion of interest rates observed in the data.

The Impact of Credit Scoring on Credit Spreads and Consumption Over the Business Cycle

Unsecured debt is the marginal source of finance for most consumers. Short run fluctuations in the credit spread on consumer unsecured debt, therefore, likely have important implications for consumer welfare. We document that the credit spread on consumer unsecured debt exhibits a persistent, hump-shaped response to an increase in the charge-off rate. This stylized fact poses a significant challenge for a standard model of consumer default in which lenders have rational expectations and, therefore, the credit spread continuously adjusts to reflect the true default incentives of each borrower. In an effort to explain this feature of the data, we construct a model of consumer default with countercyclical income risk in which lenders learn about default risk over time by observing the history of repayment decisions, as is the case in practice. In addition to matching credit spread dynamics, allowing lenders to learn about default risk substantially improves the model's ability to generate realistic business cycle fluctuations in the consumer unsecured credit market and match the cross-sectional distribution of unsecured debt and dispersion of interest rates observed in the data.

Disentangling Credit Spreads and Equity Volatility

In this paper, I provide a structural approach to quantify the forces that govern the joint dynamics of corporate bond credit spreads and equity volatility. I build a dynamic model and estimate a wide array of fundamental shocks using a large firm-level database on credit spreads, equity prices, accounting statements, and bond recovery ratios in the U.S. from 1973 to 2014. A structural decomposition reveals that the joint dynamics of credit spreads and equity volatility is driven by fluctuations in firms’ asset values and aggregate asset volatility. I find that aggregate asset volatility captures the informational content of credit spreads for predicting economic activity. All together, my results suggest that aggregate asset volatility is key for the transmission channel that links the fundamental drivers of financial indicators to the real economy.

Initial margin estimations for credit default swap portfolios

In this paper, a clearinghouse framework to establish initial margin requirements for portfolios of credit default swap instruments is presented. The estimation of portfolio risk, attributed to credit spread dynamics, features large-scale Monte Carlo simulations. It is argued that copula-based Monte Carlo implementations possess certain advantages over alternative techniques. Copula-based Monte Carlo simulations are suitable for risk management applications at clearinghouses and provide a robust, capital-efficient and flexible modeling approach to assess the risk of complex portfolios.

Treasury yields and credit spread dynamics: A regime-switching approach

The purpose of this paper is to shed new light on the conflicting empirical evidence on the relationship between credit spreads and Treasury rates. Following a general-to-specific modeling approach, we were unable to accept the presence of a long-run relationship between Baa credit spreads and long-term Treasury rates. At the same time, and in support of the structural models on credit risk modeling, a negative short-run relationship was obtained by means of impulse response functions. Subsequently, by employing a regime-switching estimation technique, we were able to establish the importance of the Treasury yield curve slope for the Baa credit spread determination in periods characterized by low interest rate volatility. Finally, we were able to provide evidence of an asymmetric response of the Baa credit spread to term spread changes according to the source of these changes, i.e. short or long term Treasury rates.

Interest Rates and Credit Spread Dynamics

Corporate credit spreads narrow when the general level of rates is high, but the effect appears to go well beyond what can be justified by firm-specific and marketwide credit conditions. In this article, the authors argue that the phenomenon is largely a statistical artifact caused by failure to take account of cointegration between Treasury and corporate yields. Using a generalized impulse-response approach and conditioning on the current level of rates, they find that large shocks to the Treasury curve do not produce significant changes in credit spreads, either contemporaneously or out to three years in the future. Among other things, this empirical result calls into question assumptions commonly made in theoretical models of corporate credit risk.

Credit Implied Volatility

The pricing of corporate credit can be succinctly understood via the credit-implied volatility (CIV) surface. We invert it each month from the firm-by-maturity panel of CDS spreads via the Merton model, transforming CDS spreads into units of asset volatility. The CIV surface facilitates direct comparison of credit spreads at different (firm leverage) and time to maturity. We use this framework to organize the behavior of corporate credit markets into three stylized facts. First, CIV exhibits a steep moneyness smirk: Low leverage (out-of-the money) CDS trade at a large implied volatility premium relative to highly levered (at-the-money) CDS, holding all other firm characteristics fixed. Second, the dynamics of credit spreads can be described with three clearly interpretable factors driving the entire CIV surface. Third, the cross section of CDS risk premia is fully explained by exposures to CIV surface shocks. Using a structural model for joint asset behavior of all firms, we show that the shape of the CIV surface implies that aggregate asset growth is subject to stochastic volatility and severe, time-varying downside tail risk. Lastly, we explore CIV of other credit instruments including corporate bonds and sovereign CDS.

Detecting Regime Shifts in Credit Spreads

AbstractUsing an innovative random regime shift detection methodology, we identify and confirm two distinct regime types in the dynamics of credit spreads: a level regime and a volatility regime. The level regime is long lived and shown to be linked to Federal Reserve policy and credit market conditions, whereas the volatility regime is short lived and, apart from recessionary periods, detected during major financial crises. Our methodology provides an independent way of supporting structural equilibrium models and points toward monetary and credit supply effects to account for the persistence of credit spreads and their predictive power over the business cycle.

Treasury Yields and Credit Spread Dynamics: A Regime-Switching Approach

Treasury Yields and Credit Spread Dynamics: A Regime-Switching Approach

The Dynamics of Credit Spreads in Hotel Mortgages and Signaling Implications

We use a vector autoregression framework to investigate loan pricing in a market with short-term leases (hotels) relative to longer-term leases (office properties), studying how news on the economy and capital markets are incorporated into the relative pricing of risk. We examine the impact of economic variables on the incremental risk premium and establish its informational content. Relative loan prices reflect systematic risk: an improvement in the general economy, an increase in forward looking corporate profitability, an increase in capital availability, and an increase in industry demand forecast a decline in the risk premium differential. We then examine how loan pricing adjusts to expected delinquencies. The spreads themselves contain important economic information and can help forecast delinquencies. Lenders are forward-looking in the pricing of risk and appear to set interest rates in anticipation of future delinquencies.

Sovereign CDS and bond credit spread dynamics in the Euro zone: evidence of an asymmetric price transmission in sovereign debt markets

In this paper, I address the price discovery process in the Euro zone sovereign credit risk markets. In particular, I analyse the dynamics between CDS spreads and bond credits spreads, which are regarded by market participants as close substitutes. Indeed, by no-arbitrage conditions there should be a close relationship between them. Recent empirical research shows that short-term deviations between the variables may arise due to market frictions, yet they disappear in the long-term. This error-correction mechanism translates into a cointegration relationship between the spreads. In contrast with recent literature and as a novelty, I show that the speed of adjustment of the error-correction mechanism may depend on the size and the sign of the departure from the long-term equilibrium relationship between credit spreads and CDS spreads. One of the implications of these findings is that deviations may even subsist in the long-run if they do not achieve a certain threshold. This asymmetric cointegration also a...

Structure in the Italian overnight loan market

We analyze the Italian interbank loan market from 1999 until 2010. The analysis of net trade flows shows a high imbalance caused by a few large net borrowers in the market. The trading volume shows a significant drop starting in 2007, which accelerates with the Lehman default in late 2008. The interbank loan network is very dense. Hence, we try to identify strong links by looking for preferential lending relationships expressed by discounts in the loan rate. Furthermore, we estimate the dynamics of credit spreads for each bank and find that economically significant spreads for the overnight market developed only in 2010. The analysis of preferential loan relationships reveals that in the pre-Lehman era large net borrowers used to borrow at a slight discount. In the post-Lehman era borrowers with large net exposures paid more than the average market rate, which shows that the risk evaluation of market participants has changed considerably.

Default and liquidity regimes in the bond market during the 2002–2012 period

AbstractUsing a real‐time random regime shift technique, we identify and discuss two different regimes in the dynamics of credit spreads during 2002–2012: a liquidity regime and a default regime. Both regimes contribute to the patterns observed in credit spreads. The liquidity regime seems to explain the predictive power of credit risk on the 2007–2009 NBER recession, whereas the default regime drives the persistence of credit spreads over the same recession. Our results complement the recent dynamic structural models as well as monetary and credit supply effects models by empirically supporting two important patterns in credit spreads: the persistence and the predictive ability toward economic downturns.

Empirical analysis of credit spread changes of US corporate bonds

In this paper we investigate the short-term credit spread dynamics of quality US corporate bonds, building on the Longstaff and Schwartz (1995) two-factor model. We find that changes in credit spreads usually display a significant negative relationship with changes in both the risk-free short interest rate and equity index returns as a proxy for asset values. Somewhat puzzlingly, however, we find that these variables do not yield a significant contribution to variations in spreads at maturities between 10 and 15years. We also argue that the relative illiquidity of the secondary market for corporate bonds may not generally allow for the immediate incorporation of information into bond prices, which affects spreads significantly.

The valuation of correlation-dependent credit derivatives using a structural model

In 1976, Black and Cox proposed a structural model in which an obligor defaults when the value of its assets hits a certain barrier. In 2001, Zhou showed that the model can be extended to two obligors whose assets are correlated. In this paper we show that the model can be extended to a large number of different obligors. The correlations between the assets of the obligors are determined by one or more factors. We examine the dynamics of credit spreads implied by the model and explore how the model prices tranches of collateralized debt obligations (CDOs). We compare the model with the widely used Gaussian copula model of survival time and test how well the model fits market data on the prices of CDO tranches. We consider three extensions of the model. The first reflects empirical research showing that default correlations are positively dependent on default rates. The second reflects empirical research showing that recovery rates are negatively dependent on default rates. The third reflects research showing that market prices are consistent with heavy tails for both the common factor and the idiosyncratic factor in a copula model.