An Empirical Examination of the Term Structure Fundamentals of Credit Spreads

Abstract

Using an exponential model of jumps to default, this research investigates the fundamentals that determine the spreads required by investors for corporate credit risk at different maturities. The empirical results indicate that CDS prices across the term spectrum are strongly associated with interrelated probabilities of cash, income, and valuation insolvency, as well as with market-based measures of systematic risk. Although the financial functions best fitting CDS prices are found to vary somewhat by maturity, an integrated model with constant parameters across time, company, and term is found to explain about 50% of individual credit spreads both in sample and ex-post.

TOPICS: Credit risk management, credit default swaps

Key Findings

• • Using nonnegative least squares procedures to find the structural model forms which best fit credit spreads across the term structure, this empirical research explains over half of individual CDS prices in and out of sample.

• • CDS prices with shorter terms (like 1–3 years) are found to be most strongly determined by the probability of a company generating negative income and running out of cash, but the likelihood of cash and income insolvency is discovered to also have important impacts at longer maturities of 5–10 years.

• • The 378,401 individual credit spreads in the sample over the 2008–2019 interval are found to incorporate time-varying systematic risk premiums (estimated from market prices), as well as reflect the integrated risks of income, cash, and valuation insolvency on any day.