Corporate Yield Spreads: Default
Risk or Liquidity?
New Evidence from the Credit
Default Swap Market
Professor Francis Longstaff
UCLA/Anderson School
Introduction
ƒ How are corporate bonds priced in the
market?
ƒ In theory, corporate spreads should be fully
explained by default risk.
ƒ In practice, many studies find that default
risk only explains a small (5 to 25 %)
fraction of corporate spreads.
Introduction
ƒ We use the information in credit-default
swaps to directly measure the size of the
default component in corporate spreads.
ƒ This also allows us to study the properties of
the nondefault component of corporate
spreads.
CDS Contracts
ƒ A credit-default swap has two legs.
ƒ Buyer of protection pays a quarterly annuity
until either end of contract or a default.
ƒ If there is a default, buyer of protection can
put bond back to protection seller at its par
value.
ƒ We use an extensive data set on CDS
prices and corporate bond yield provided by
Citigroup global credit derivatives business.
The Approach
ƒ We use closed-form Duffie-Singleton model
to value bonds and CDS contracts.
ƒ We fit the model simultaneously to corporate
yields and CDS premia.
ƒ We use fitted model to imply the size of the
default component for 76 firms.
ƒ We study the properties of the default and
nondefault components of corporate
spreads.
Findings
ƒ Most of the spread is due to default risk.
ƒ The nondefault component is due mostly to
a general bond market liquidity factor, and
individual corporate bond illiquidity features.
A CDS Term Sheet
Term Sheet
Term Sheet
Term Sheet
ƒ
Percent due to Credit