Market conditions, default risk and credit spreads

Abstract

This study empirically examines the impact of the interaction between market and default risk on corporate credit spreads. Using credit default swap (CDS) spreads, we find that average credit spreads decrease in GDP growth rate, but increase in GDP growth volatility and jump risk in the equity market. At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads generally rise with cash flow volatility and beta, with the effect of cash flow beta varying with market conditions. We identify implied volatility as the most significant determinant of default risk among firmlevel characteristics. Overall, a major portion of individual credit spreads is accounted for by firm-level determinants of default risk, while macroeconomic variables are directly responsible for a lesser portion.

Investor sentiment, flight-to-quality, and corporate bond comovement

“…Nayak (2010) finds that corporate bond spreads are affected by investor sentiment. Tang and Yan (2010) show that market-wide credit spreads negatively depend on investor sentiment. We add to this literature by showing that low investor sentiment leads to high risk factor correlation and, ultimately, high bond correlation.…”

Determinants of credit default swaps spreads in European and Asian markets

“…The credit rating information is another important factor in determining CDS spreads (Cossin and Hricko, 2001). Tang and Yan (2008), however, use Moody's KMV Expected Default Frequency (EDF), instead of Moody's and S&P credit ratings, as a measure of default probability. They claim that EDF has the advantage of being frequently updated of credit conditions as the indicator is based on the stock price of the reference firm.…”

“…This result holds for all rating categories and the riskless curve Altman et al (2005) Firm-specific variables add little in terms of explanatory power or incremental statistical significance to the CDS spread Tang and Yan (2006) The paper constructs liquidity proxies to capture various aspects of CDS liquidity and examines its impact with adverse selection and inventory constraints. They find that both liquidity level and liquidity risk are significant factors in determining CDS spreads Cremers et al (2008) Option-implied jump risk measures explain a significant part of observed credit spread as measured by CDS spread Tang and Yan (2008) Macroeconomic conditions have a significant impact on CDS spreads. Also, it provides further evidence on the importance of the interaction between market conditions and firm-specific characteristics Imbierowicz (2009) The paper suggests that portfolio positions have to be evaluated constantly and related to their truly fundamental value, otherwise you risk mispricing, and that present structural pricing models do not capture all important factors on CDS and that we must consider the importance of forward-looking macro-indicators as well as liquidity measures and the incorporation of implied volatilities Li (2007) Systematic risk proportion has a negative and significant effect on the CDS spreads after including variables that are suggested by theories of default risk and the extant empirical evidence.…”

“…Many papers have considered aggregate economic variables as potential explanatory variables of credit conditions. For example, they incorporate the aggregate level of interest rates, leverage, inflation, unemployment, consumer confidence, aggregate measures of indebtedness, nominal and real GDP growth rates, changes in GDP growth rates, national savings rates, market liquidity premiums, the ratio of high yield debt to total debt outstanding, and returns as well as volatility of equity indices (Imbierowicz, 2009;Pu and Zhao, 2010;Tang and Yan, 2008).…”

“…In addition, these variables are examined in conjunction with a number of firm-specific factors as well as industry-, sector-and/or geography-fundamentals, such as the degree of corporate leverage, the ratio of free operating cash flow to total debt, Earnings Before Interest and Taxes/Earnings Before Interest, Taxes, Depreciation and Amortization (EBIT/ EBITDA), Return On Assets (ROA), Return On Equity (ROE), dividend payout, interest coverage multiples, earning forecast, industrial production percentage, liquidity, treasury yields, option-implied volatility, jump risk, systematic risk, default probability and credit rating (Ericsson et al, 2004;Hull et al, 2004;Longstaff et al, 2005;Tang and Yan, 2006;Cremers et al, 2008;Li, 2007;Imbierowicz, 2009;Pu and Zhao, 2010;Tang and Yan, 2008;Zhang et al, 2009).…”