Term Structure Of Credit Spreads Research Articles

The fed takes on corporate credit risk: An analysis of the efficacy of the SMCCF

This paper evaluates the efficacy of the Secondary Market Corporate Credit Facility, a program designed to stabilize the U.S. corporate bond market during the COVID-19 pandemic. The program announcements on March 23 and April 9, 2020, significantly reduced investment-grade credit spreads across the maturity spectrum—irrespective of the program’s maturity-eligibility criterion—and ultimately restored the normal upward-sloping term structure of credit spreads. The Federal Reserve’s actual purchases reduced credit spreads of eligible bonds 3 basis points more than those of ineligible bonds, a sizable effect given the modest volume of purchases. A calibrated variant of the preferred habit model shows that a “dash for cash”—a selloff of shorter-term lowest-risk investment-grade bonds—combined with a spike in the arbitrageurs’ risk aversion, can account for the inversion of the investment-grade credit curve during the height of turmoil in the market. Consistent with the empirical findings, the Fed’s announcements, by reducing risk aversion and alleviating market segmentation, helped restore the upward-sloping credit curve in the investment-grade segment of the market.

A comparative study of firm value models: Default risk of corporate bonds

This paper presents a regime-switching normal tempered stable (NTS) firm value model for pricing default risk, based on an N-state continuous Markov chain process and an underlying NTS process. The derived regime switching characteristic function enables closed-form expressions for corporate bond credit spreads, with the model’s innovation arising from substituting the characteristic function of the existing NTS firm value model. This approach is assumed to capture hidden factors affecting default risk pricing. Calibration for the term structure of US corporate industrial credit spread demonstrates the model’s superior fit across all credit ratings compared to NTS and Merton firm value models.

Accounting Information Completeness and Firm Default Risk

Corporate debt market is crucial to raise capital for businesses and to maintain steady economic growth. Disclosure with more complete accounting information provides more informative signals for investors to assess a firm’s risk of defaulting on its debt, which is the fundamental mechanism of the seminal theory by Duffie and Lando [2001, Term Structures of Credit Spreads with Incomplete Accounting Information, Econometrica 69(3), 633–664]. Using a disclosure quality measure that captures the completeness of accounting information in the income statement and balance sheet, we show that a firm’s default risk is significantly and negatively associated with the completeness of its accounting information. We further show that the negative relation is mainly driven by the information completeness of the balance sheet, relative to that of the income statement. In addition, the information completeness of the long-term liabilities on the balance sheet better explains a firm’s default risk, compared to the current liabilities. Overall, our findings provide new evidence on the importance of accounting information completeness for both firms and investors in the debt market.

Incomplete Information, Debt Issuance, and the Term Structure of Credit Spreads

We derive a firm’s debt issuance policy when managers have an informational advantage over creditors and face debt restructuring costs. In our model, regardless of how poor their private signal is, managers of firms that can access the credit market avoid default by issuing new debt to service existing debt. Therefore, only bonds of firms that have exhausted their ability to borrow are subject to jump-to-default risk because of incomplete information and, in turn, command a jump-to-default risk premium. We document that our model captures many salient features of the corporate bond market. This paper was accepted by Kay Giesecke, finance. Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2022.4529 .

Common Factors in the Term Structure of Credit Spreads and Predicting the Macroeconomy in Japan

This study extracts the common factors from firm-based credit spreads of major Japanese corporate bonds and examines the predictive content of the credit spread on the real economy. Instead of employing single-maturity corporate bond spreads, we focus on the entire term structure of the credit spread to predict the business cycle. We extend the dynamic Nelson-Siegel model to allow for both common and firm-specific factors. The results show that the estimated common factors are important drivers of individual credit spreads and have substantial predictive power for future Japanese economic activity. This study contributes to the literature by examining the relationship between firm-based credit spread curves and economic fluctuation and forecasting the business cycle.

Systematic risk, debt maturity, and the term structure of credit spreads

We document several facts about corporate debt maturity: (1) debt maturity is pro-cyclical, (2) higher-beta firms tend to have longer maturity, and (3) shorter maturity amplifies the sensitivity of credit spreads to aggregate shocks. We present a dynamic capital structure model that explains these facts. In the model, leverage and maturity choices are interdependent, which reflect the tradeoffs of liquidity discounts of long-term debt, repayment risks of short-term debt, and the benefit of short-term debt as a commitment device for timely leverage adjustments. Additionally, the model helps quantify the effects of maturity dynamics on the term structure of credit spreads.

Government Debt Maturity and Term Structure of Credit Spreads

We investigate how government borrowing behaviors influence private sectors by exploring the relationship between government debt maturity and credit term structures. Using individual corporate bonds data between 1987 and 2015, we find that a longer government debt maturity is associated with a steeper credit term structure in both the primary and secondary corporate bond markets. An instrumental variable approach and an exogenous event study help us establish a causality. Our findings are more pronounced among riskier corporate bonds, and the influences of Treasury bond supply on credit term spreads are more pronounced near the maturity where this supply shock originates, suggesting that the credit risk and the maturity clientele channels together drive our findings.

Predicting corporate bankruptcy using the framework of Leland-Toft: evidence from U.S.

In this paper, we evaluate an alternative approach for bankruptcy prediction that measures the financial healthiness of firms that have coupon-paying debts. The approach is based on the framework of Leland, H. and Toft, K.B. [Optimal capital structure, endogenous bankruptcy and the term structure of credit spreads. J. Financ., 1996, 51, 987–1019], which is an extension of a widely-used model; the Black–Scholes–Merton model. Using U.S. public firms between 1995 and 2014, we show that the Leland-Toft approach is more powerful than Black–Scholes–Merton in a variety of tests. Moreover, extending popular but also contemporary corporate bankruptcy models with the probability of bankruptcy derived from the Leland-Toft model, such as Altman, E. [Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. J. Financ., 1968, 23, 589–609], Ohlson, J.A. [Financial ratios and the probabilistic prediction of bankruptcy. J. Account. Res., 1980, 18, 109–131] and Campbell, J. Y., Hilscher, J. and Szilagyi, J. [In search of distress risk. J. Financ., 2008, 63, 2899–2939], yields models with improved performance. One of our tests, for example, shows that banks using these extended models, achieve superior economic performance relative to other banks. Our results are consistent under a comprehensive out-of-sample framework.

Fiscal Limits and Sovereign Credit Spreads

Exploiting information contained in the term-structure of sovereign credit spreads, we estimate time-varying fiscal limits – defined as the maximum outstanding debt that can credibly be covered by future primary budget surpluses. Our approach is based on a novel sovereign credit risk model accounting for the joint dynamics of debt, the fiscal limit, and bond prices. The empirical analysis is carried out on ten OECD economies, covering the period from 2007 to 2018. Our fiscal limit estimates feature substantial time-variation. In line with a wide range of empirical evidence, our framework captures the nonlinear sensitivities of credit spreads to fiscal conditions. We also obtain sizeable estimates of sovereign credit risk premiums – the components of sovereign spreads that would not exist if agents were risk-neutral.

Asymmetric Information, Dynamic Debt Issuance, and the Term Structure of Credit Spreads

We propose a tractable bond pricing model in which managers have an informational advantage over creditors. We show that, regardless of how poor their private signal is, managers of firms that can access the credit market will avoid default by issuing new debt to service existing debt. Therefore, only bonds of firms that have exhausted their ability to borrow are subject to jump-to-default risk due to incomplete information and, in turn, command a jump-to-default risk premium. We document that our model captures many salient features of the corporate bond market.

Is Thailand’s credit default swap market linked to bond and stock markets? Evidence from the term structure of credit spreads

When the term structure of credit spreads is used in a panel vector autoregression model, Granger causality tests provide strong evidence of bi-directional relationships among CDS, bond and stock markets. This study argues that extant research using only a 5-year credit spread tends to understate intermarket linkages since in practice investors are able to trade credit risk over the entire term structure of credit spreads. Interestingly, this study produces new empirical evidence that the term structure of CDS-bond basis displays a monotonically increasing trajectory. As the maturity lengthens, the arbitrage opportunity of companies with negative (positive) CDS-bond basis decreases (increases).

Tempered stable structural model in pricing credit spread and credit default swap

In this paper, we explore the features of a structural credit risk model wherein the firm value is driven by normal tempered stable (NTS) process belonging to the larger class of Levy processes. For the purpose of comparability, the calibration to the term structure of a corporate bond credit spread is conducted under both NTS structural model and Merton structural model. We find that NTS structural model provides better fit for all credit ratings than Merton structural model. However, it is noticed that probabilities of default derived from the calibration of the term structure of a bond credit spread might be overestimated since the bond credit spread could contain non-default components such as illiquidity risk or asymmetric tax treatment. Hence, considering CDS spread as a reflection of the pure credit risk for the reference entity, we calibrate it in order to obtain more reasonable probability of default and obtain valid results in calibration of the market CDS spread with NTS structural model.

The term structure of credit spreads and business cycle in Japan

This paper investigates the usefulness of the term structure of credit spreads to predict the business cycle in Japan. Our analyses provide clear evidence that the term structure of credit spreads has more predictive power than the government bond yield. Specifically, the paper shows that the credit spread curve of medium-grade corporate bonds has more useful information than the government bond yield curve for predicting the business cycle. However, our results indicate that the increase in the BBB-rated credit spread is associated with future economic expansion, contradicting the theoretical prediction in the existing literature. Our Markov-switching analysis demonstrates that this peculiar relationship holds only during the global financial crisis regime, and the 1-year government bond yield and the term spread of A-rated credit spread information have significant predictive power for the business cycle, regardless of the economic state.

The term structure of credit spreads, firm fundamentals, and expected stock returns

We explore the link between credit and equity markets by considering the informational content of the term structure of credit spreads. A shallower credit term structure predicts decreases in default risk and increases in future profitability, as well as favorable earnings surprises. Further, the slope of the credit term structure negatively predicts future stock returns. While systematic slope risk is priced, information diffusion from the credit market to equities, particularly in less visible stocks, plays an additional role in accounting for return predictability from credit slopes. That is, such predictability is less evident in stocks with high institutional ownership, analyst coverage, and liquidity, and vice versa.

Testing the Transparency Implications of Mandatory IFRS Adoption: The Spread/Maturity Relation of Credit Default Swaps

This study tests whether international financial reporting standards (IFRS) adoption increased accounting transparency based on model-driven hypotheses. Duffie and Lando [Duffie D, Lando D (2001) Term structures of credit spreads with incomplete accounting information. Econometrica 69(3):633–644] show that changes to accounting transparency affect the spread/maturity relation of credit default swap (CDS) instruments in very specific ways. Consistent with their model, we find that CDS spreads are lower across maturities following the adoption of IFRS, and the slope and concavity of the CDS spread/maturity relation are higher. These changes did not occur to the spread/maturity relation of a control sample of CDS instruments. Predicted changes apply more intensely to firms with low pre-IFRS transparency. Overall, this study provides strong evidence that IFRS adoption increased accounting transparency. This paper was accepted by Mary Barth, accounting.

A Gaussian Affine Term Structure Model of Interest Rates and Credit Spreads

We estimate a no-arbitrage term structure model of U.S. Treasury yields and corporate bond spreads with both economic factors and latent factors as drivers of term structure dynamics. We consider two sets of economic factors: macro factors consisting of inflation and real activity, and financial market factors consisting of funding liquidity and market volatility. We show that financial market factors have limited effects on the Treasury yield curve but substantial impacts on the credit spread term structure. In particular, negative liquidity shocks widen credit spreads, and this effect is more pronounced for short-term corporate bonds. We also find that out-of-sample forecasts for credit spreads improve when financial market factors are incorporated and when no-arbitrage restrictions are imposed. We also propose a minimum-chi-square method for estimating the term structure models of interest rate and credit spreads, which is more efficient and accurate than the widespread maximum-likelihood estimation.

The Term Structure of Credit Spreads and Business Cycle in Japan

This paper investigates the usefulness of the term structure of credit spreads to predict the business cycle in Japan. Our analyses provide clear evidence that the term structure of credit spreads has more predictive power than the government bond yield. Specifically, the paper shows that the credit spread curve of medium-grade corporate bonds with an A or BBB rating has more useful information than the government bond yield curve for predicting the business cycle in Japan. However, our results indicate that the increase in the BBB-rated credit spread is associated with future economic growth, contradicting the theoretical prediction in the existing literature. Our Markov-switching analysis demonstrates that this peculiar relationship holds only during the global financial crisis regime, and the 1-year government bond yield and the term spread of A-rated credit spread information have significant predictive power for the business cycle in Japan regardless of the economic state.

CoCos under short-term uncertainty

In this paper we analyze an extension of the Jeanblanc and Valchev model by considering a short-term uncertainty model with two noises. It is a combination of the ideas of Duffie and Lando (Term structure of credit spreads with incomplete accounting 25 information, Econometrica 69 (2001), pp. 633–664) and Jeanblanc and Valchev (Partial information and hazard process, Int. J. Theor. Appl. Finance 8 (2005), pp. 807#x2013;838): share quotations of the firm are available at the financial market, and these can be seen as noisy information about the fundamental value, or the firm’s asset, from which a low level produces the credit event. We assume there are also reports of the firm, release times, where this short-term uncertainty disappears. This credit event model is used to describe conversion and default in a CoCo bond.

Structural Credit Risks with Non-Gaussian and Serially Correlated Innovations

SYNOPTIC ABSTRACTWe expand the Merton's structural credit risk model into a model that includes an underlying asset process with a non-Gaussian and serially correlated stochastic nature. Using a standard Edgeworth expansion, we arrive at closed-form analytic expressions for the probability of default, the distance to default, and the term structure of credit spread, allowing us to evaluate more accurately the credit risk of incorporating nonnormal asset returns. Moody's KMV (Kealhofer, McQuown, and Vasicek) analogous procedures are proposed for the estimation of the model parameters. Empirical applications for credit-risk evaluation are illustrated, which reveal the significant effects on credit risk due to the non-Gaussianity of the underlying firm's asset process.

A defaultable HJM modelling of the Libor rate for pricing Basis Swaps after the credit crunch

A great deal of recent literature discusses the major anomalies that have appeared in the interest rate market following the credit crunch in August 2007. There were major consequences with regard to the development of spreads between quantities that had remained the same until then. In particular, we consider the spread that opened up between the Libor rate and the OIS rate, and the consequent empirical evidence that FRA rates can no longer be replicated using Libor spot rates due to the presence of a Basis spread between floating legs of different tenors. We develop a credit risk model for pricing Basis Swaps in a multi-curve setup. The Libor rate is considered here as a risky rate, subject to the credit risk of a generic counterparty whose credit quality is refreshed at each fixing date. A defaultable HJM methodology is used to model the term structure of the credit spread, defined through the implied default intensity of the contributing banks of the Libor corresponding to a chosen tenor. A forward credit spread volatility function depending on the entire credit spread term structure is assumed. In this context, we implement the model and obtain the price of Basis Swaps using a numerical scheme based on the Euler–Maruyama stochastic integral approximation and the Monte Carlo method.