Term Structure Of Spreads Research Articles

Is climate transition risk priced into corporate credit risk? Evidence from credit default swaps

We study whether climate transition risk is reflected in the credit default swap (CDS) spreads of European firms. Using information on the vulnerability of a firm’s value to the transition to a low-carbon economy, we construct a climate transition risk (CTR) factor, and report how this factor shifts the term structure of the CDS spreads of more but not of less vulnerable firms. Considering the CTR factor, we find that different climate transition policies have asymmetric and significant economic impacts on the credit risk of more vulnerable firms, and negligible effects on less vulnerable firms.

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.

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.

A Joint Analysis of the Term Structure of Credit Default Swap Spreads and the Implied Volatility Surface

A Joint Analysis of the Term Structure of Credit Default Swap Spreads and the Implied Volatility Surface

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 .

Geometry and Spectral Theory Applied to Credit Bubbles in Arbitrage Markets: The Geometric Arbitrage Approach to Credit Risk

We apply Geometric Arbitrage Theory (GAT) to obtain results in mathematical finance for credit markets, which do not need stochastic differential geometry in their formulation. The remarkable aspect of the GAT is the gauge symmetry, which can be translated to the financial context, by packaging all of the asset model information into a (stochastic) principal fiber bundle. We obtain closed-form equations involving default intensities and loss-given defaults characterizing the no-free-lunch-with-vanishing-risk condition for government and corporate bond markets while relying on the spread-term structure with default intensity and loss-given default. Moreover, we provide a sufficient condition equivalent to the Novikov condition implying the absence of arbitrage. Furthermore, the generic dynamics for an isolated credit market allowing for arbitrage possibilities (and minimizing the total quantity of potential arbitrage) are derived, and arbitrage credit bubbles for both base credit assets and credit derivatives are explicitly computed. The existence of an approximated risk-neutral measure allowing the definition of fundamental values for the assets is inferred through spectral theory. We show that instantaneous bond returns are serially uncorrelated and centered, that the expected value of credit bubbles remains constant for future times where no coupons are paid, and that the variance of the market portfolio nominals is concurrent with that of the corresponding bond deflators.

A three-factor hazard rate model for single-name credit default swap pricing

We propose a reduced-form model that integrates the modeling of interest rates, equity and default hazard rates. In this model the evolution of the risk-neutral hazard rate is driven by three risk factors: the reference firm’s equity price (in logarithmic form), the risk-free short rate and a latent risk premium factor that is orthogonal to the first two. The equity price and the short rate are considered to be the two primary risk factors, while the risk premium factor is introduced to capture the remaining risks for the hazard rate (such as the liquidity risk). The equity price follows a diffusion process with the possibility of a jump to default, the short rate is governed by a Vasicek model, and the dynamics of the risk premium factor are modeled as a Cox– Ingersoll–Ross process. Under the three-factor model, we derive computable pricing formulas for defaultable zero-coupon bonds, European call options and standard running credit default swaps (CDSs).We then discuss the calibration of the model using CDS and equity option data. Our numerical results reveal that the model is able to interpret a diverse set of CDS spread term structures.

Corporate social responsibility and the term structure of CDS spreads

This paper examines the role of corporate social performance in the CDS market, with a focus on the differential effect conditional on the lengths of time horizons. We find that firm’s strong social performance negatively predicts the slope of CDS term structure, by reducing the long-term credit risk and increasing the short-term credit risk. After controlling for credit ratings in a “path analysis”, we find that the direct effect of social performance remains significant, suggesting that CDS market participants incorporate this information more efficiently than credit rating agencies. Furthermore, the effects of social performance are stronger for firms with speculative-grade ratings, smaller size, or less analyst coverage. Our findings remain robust to alternative proxy for credit term structure based on S&P ratings or to the sample without the 2008 Financial Crisis period.

How to estimate expected credit losses – ECL – for provisioning under IFRS 9

PurposeThis paper provides an objective approach based on available market information capable of reducing subjectivity, inherently present in the process of expected loss provisioning under the IFRS 9.Design/methodology/approachThis paper develops the two-step methodology. Calibrating the Credit Default Swap (CDS)-implied default probabilities to the through-the-cycle default frequencies provides average weights of default component in the spread for each forward term. Then, the impairment provisions are calculated for a sample of investment grade and high yield obligors by distilling their pure default-risk term-structures from the respective term-structures of spreads. This research demonstrates how to estimate credit impairment allowances compliant with IFRS 9 framework.FindingsThis study finds that for both investment grade and high yield exposures, the weights of default component in the credit spreads always remain inferior to 33%. The research's outcomes contrast with several previous results stating that the default risk premium accounts at least for 40% of CDS spreads. The proposed methodology is applied to calculate IFRS 9 compliant provisions for a sample of investment grade and high yield obligors.Research limitations/implicationsMany issuers are not covered by individual Bloomberg valuation curves. However, the way to overcome this limitation is proposed.Practical implicationsThe proposed approach offers a clue for a better alignment of accounting practices, financial regulation and credit risk management, using expected loss metrics across diverse silos inside organizations. It encourages adopting the proposed methodology, illustrating its application to a set of bond exposures.Originality/valueNo previous research addresses impairment provisioning employing Bloomberg valuation curves. The study fills this gap.

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.

A study on the relationship between the term structure of Japanese corporate bond spreads and the macro economy

Dr Takeshi Kobayashi, Professor of Business School of Nagoya University of Commerce and Business, is carrying out research which explores credit spreads and macroeconomic variables through a range of methodologies. He is hoping to gain new perspecitves and knowledge in this area by bridging the gap between finance and academia through detailed empirical analyses of corporate bond spreads and the relationship to macroeconomic variables.

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.

The flight from maturity

Why did the failure of Lehman Brothers make the financial crisis dramatically worse? Our answer is that the financial crisis was a process of a build-up of risk during the crisis prior to the Lehman failure. During the crisis market participants tried to preserve an option to withdraw by shortening maturities — the “flight from maturity”. We show that the flight from maturity was manifested in a steepening of the term structures of spreads in money markets. With increasingly short maturities, lenders created the possibility of fast exit. The failure of Lehman Brothers was the tipping point of this build-up of systemic fragility. A crisis is a dynamic process in which “tail risk” is endogenous.

Estimating the term structure of corporate bond liquidity premiums: An analysis of default free bank bonds

Using proxies for conversion cost parameters in conjunction with a special set of default free corporate bonds, we empirically establish that the term structure of liquidity spreads was positively sloped in the financial crisis period of 2008 and negatively sloped in the subsequent post crisis period. Importantly, these results indicate the segment of the term structure that provides the largest liquidity premiums to lenders for alternative economic scenarios. At the same time, for different financial epochs, the liquidity spreads associated with different times to maturity are clear to those who issue debt.

Modeling CDS spreads: A comparison of some hybrid approaches

Abstract According to the credit risk model proposed by Cathcart and El-Jahel (2006), default can occur either expectedly, when a certain signaling variable breaches a lower barrier, or unexpectedly, as the first jump of a Poisson process, whose intensity depends on the signaling variable itself and on the interest rate. In the present paper we test the performances of such a model and of other three models generalized by it in fitting the term structure of credit default swap (CDS) spreads. In order to do so, we derive a semi-analytical formula for pricing CDSs and we use it to fit the observed term structures of 65 different CDSs. The analysis reveals that all the model parameters yield a relevant contribution to credit spreads. Moreover, if the dependence of the default intensity on both the signaling variable and the interest rate is removed, the pricing of CDSs becomes very simple, from both the analytical and the computational standpoint, while the goodness-of-fit is reduced by only a few percentage points. Therefore, when using the credit risk model proposed by Cathcart and El-Jahel (2006), assuming a constant default intensity provides an interesting and efficient compromise between parsimony and goodness-of-fit. Furthermore, by fitting the term structure of CDS spreads on a period of about twelve years, we find that the parameters of the model with constant default are rather stable over time, and the goodness-of-fit is maintained high.

Term Structure of CDS Spreads and Risk-Based Capital of the Protection Seller: An Extension of the Dynamic Nelson–Siegel Model with the Business Cycle

This article proposes an extended Diebold-Li dynamic Nelson-Siegel model with factors following AR-GARCH processes to fit the term structure of CDS spreads. The proposed model is used to estimate the risk-based capital of a protection seller of CDS contracts. Using CDX North American Investment Grade Index and CDX North American High Yield Index data, we find the AR-GARCH process with the business cycle to outperform all the other models. The risk-based capital for a protection seller increases with the duration of the holding period. Moreover, the protection seller of CDS contracts on high-yield reference entity needs capital-at-risk at least twice the amount that is needed for similar CDS on the investment-grade reference entity. The observed high level of capital-at-risk is driven mainly by the high volatility period identified in our sample, because the low volatility period is characterized by low realized defaults and persistent decline in CDS spreads. TOPICS:Factor-based models, credit default swaps Key Findings • This paper proposes an extended version of the Diebold-Li dynamic Nelson-Siegel (DNS) model to fit the term structure of CDS spreads; with a family of AR-GARCH process with business cycle to capture the dynamics of the conditional mean and the conditional volatility of CDS spreads. • Using data on the CDX North American Investment Grade index (CDXIG) and the CDX North American High Yield index (CDXHY), the proposed model is used to determine the risk-based capital of a protection seller of CDS contracts. • Overall, the proposed AR-GARCH process with the business cycle outperforms all the other processes (AR, AR-GARCH, AR-EGARCH, and AR-GJR), which highlights the importance of the business cycle to better forecast CDS 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.

IFRS 9 compliant economic adjustment of expected credit loss modeling

This paper presents an International Financial Reporting Standard 9 (IFRS 9) compliant solution related to expected credit loss modeling. Commonly, credit default swap (CDS) spreads are considered as market indicators of future debt performance. However, we demonstrate empirically that nondefault risks explain a relevant part of the CDS spread, and we assess the average weight-of-default component for each point in the CDS spread term structure. Thus, to be used for probability of default estimations, CDS spreads must be adjusted for the nondefault component to guarantee the neutral character of expected credit loss estimations, as required by IFRS 9. Our study introduces an innovative methodology for extracting the pure default component and probability of default calibration. To enable economic adjustment of probabilities of default we analyze the relationship between a long-run average of the across-the-sample mean CDS spread of the homogeneous cohort of issuers and the spread implied by the long-run average of the observed default rates. Our easy-to-implement solution is applied to a sample of investment-grade and high-yield corporate debt issuers. We exploit differences in the economic performance of North American and eurozone obligors. The proposed framework allows us to understand complex interactions between the forward-looking impairment provisions and economic capital requirements in relation to credit losses.

Sovereign credit risk and exchange rates: Evidence from CDS quanto spreads

Sovereign credit default swap quanto spreads tell us how financial markets view the interaction between a country’s likelihood of default and associated currency devaluations (the Twin Ds). A no-arbitrage model applied to the term structure of eurozone quanto spreads can isolate the Twin Ds and can gauge the associated risk premiums. Conditional on the occurrence of default, the true and risk-adjusted one-week probabilities of devaluation are 42% (2%) and 90% (55%) for the core (periphery) countries. The weekly risk premium for euro devaluation in case of default for the core (periphery) exceeds the regular currency premium by up to 18 (13) basis points.

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.