Correlated Default Risk

Abstract

Fixed-Income portfolios are increasingly susceptible to correlated default risk. Defaults of individual firms will cluster if there are common factors that affect each firm's default risk. Using a comprehensive dataset of firm-level default probabilities, we examine co-variation of default probabilities across U.S. public non-financial firms. We observe that systematic time-variation in default risk is driven more by an economy-wide volatility factor than by changing debt levels, and therefore is closely linked to the business cycle. Specifically, both default probabilities and default correlations vary over time resulting in substantial variation in joint default risk. For example, over the latter half of the 1990s, default probabilities across the economy doubled, and correlations increased by an even greater magnitude. We provide a reduced-form framework to jointly model time variation in both default probabilities and their correlations over the business cycle. Calibration of the model demonstrates the economic importance of modeling time-variation of joint default risk; for example, our model suggests that the ex-ante probability of observing the record defaults of 2001 doubled across regimes. We also document cross-sectional differences across rating classes—default probability correlations are higher amongst higher quality issuers.