Solving the Spread Curve Puzzle

Abstract

The credit spread curve is the difference in spread-versus-Treasuries between long-maturity and short-maturity issues. Two articles published in the 1990s reached opposite conclusions regarding whether the slope of that curve is positive or negative. The authors find that neither study uncovered the essential point that the curve is negatively sloped in most periods but positively sloped in periods of exceptionally low perceived credit risk. The true explanation of the shape of the credit spread curve lies in the shift in valuation metric from spread-versus-Treasuries to price as a percentage of face value as default risk increases.

TOPICS: Fixed income and structured finance, statistical methods, credit risk management