Decomposing Risks in Bond Portfolios: International Evidence

Abstract

This study recalibrates corporate bond idiosyncratic risks in an international context. By applying a statistically powerful risk decomposition scheme, the authors show that diversification is significantly improved by the addition of a global risk benchmark. They construct a long-run stationary yield spread decomposition scheme that further provides a better diversification effect. In addition to global liquidity and default risk factors, a country-specific default risk component is included, and all of them are free of measurement or availability issues. The idiosyncratic risk component is estimated as a fixed effect along with all the parameter estimates, rather than separately from an exogenous generating process. The linear model is simple, yet it can be easily and promptly applied by practitioners.

TOPICS: Fixed income and structured finance, factor-based models, credit risk management