Do We Need to Worry about Credit Risk Correlation?

Abstract

Yes we do. This article shows that any firm's credit risk is, to a very large extent, driven by common risk factors affecting all firms. Using a reduced form model and sequential Kalman filtering estimation, we decompose the credit risk of a sample of corporate bonds (14 U.S. firms, 2001–2003) into different unobservable risk factors. A single common factor accounts for more than 50% of all (but two) of the firms' credit risk levels, with an average of 68% across firms. This factor represents the credit risk levels underlying the U.S. economy and is strongly correlated with main U.S. stock indexes.