Explaining the Rate Spread on Corporate Bonds
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In this article, the authors examined and explained the differences in the rates offered on corporate bonds and those offered on government bonds, and examined whether there is a risk premium in corporate bond spreads and, if so, why it exists.Abstract:
The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. THE PURPOSE OF THIS ARTICLE is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds ~spreads!, and, in particular, to examine whether there is a risk premium in corporate bond spreads and, if so, why it exists. Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons: 1. Expected default loss—some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium—interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium—The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable. The only controversial part of the above analyses is the third point. Some authors in their analyses assume that the risk premium is zero in the corporate bond market.1read more
Citations
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Forecasting Default with the Merton Distance to Default Model
TL;DR: In this paper, the authors examined the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model, and compared the model to a "naive" alternative, which uses the functional form suggested by Merton model but does not solve the model for an implied probability of default.
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The Determinants of Credit Spread Changes
TL;DR: In this article, the determinants of credit spread changes were investigated using dealer's quotes and transactions prices on straight industrial bonds, and the residuals from this regression are highly cross-correlated, and principal components analysis implies they are mostly driven by a single common factor.
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Default Risk in Equity Returns
Maria Vassalou,Yuhang Xing +1 more
TL;DR: In this paper, the authors used Merton's option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns and found that default risk is systematic risk.
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Credit Spreads and Business Cycle Fluctuations
Simon Gilchrist,Egon Zakrajsek +1 more
TL;DR: In this paper, the authors examined the relationship between credit spreads and economic activity, by constructing a credit spread index based on an extensive data set of prices of outstanding corporate bonds trading in the secondary market and found that the predictive content of credit spreads for economic activity is due primarily to movements in the excess bond premium.
Journal ArticleDOI
Default Risk in Equity Returns
Maria Vassalou,Yuhang Xing +1 more
TL;DR: In this paper, the authors used Merton's option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns and found that default risk induces lenders to require from borrowers a spread over the risk-free rate of interest.
References
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