Researcher Develops New Approach For Estimating Corporate-Treasury Yield Spread

Researcher Develops New Approach For Estimating Corporate-Treasury Yield Spread

UNIVERSITY PARK, PA-Corporate bonds typically trade at a higher rate of return than Treasury bonds of comparable maturities. The yield spread is partly due to the credit risk of corporate bonds, but there has never been a consensus estimate on how much of the corporate-Treasury yield spread is due to credit risk.

Jingzhi "Jay" Huang of Penn State's Smeal College of Business recently co-authored a paper that proposes a new calibration approach to estimating how much of the corporate-Treasury yield spread is due to credit risk. The paper, "How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk: A New Calibration Approach," was co-authored with Ming Huang of Stanford University.

"Our results show that, typically, only a small part of the observed corporate-Treasury yield spread is due to credit risk. We also found, for investment-grade bonds, that the fraction of yield spread attributable to credit risk is lower for bonds of shorter maturities," says Huang, assistant professor of finance in Smeal College.

He notes that the fraction of the yield spread attributable to credit risk is higher for corporate bonds with lower credit ratings, which is reasonable given that credit risk may be more important for bonds of low credit quality, relative to other factors such as liquidity and call features.

In order to find the level of credit risk, the researchers first calibrate selected structural models with historical default frequency and default loss rate, and then use the calibrated models to calculate the appropriate level of corporate-Treasury yield spread that is attributable to credit risk.

One way to view the researchers' approach is as follows: The credit spread of a corporate bond depends on probability of default; loss rate upon default and the risk of premium of default risk. Their calibration approach ensures that the calibrated model for a bond of a given rating captures the first two factors with reasonable precision. The third factor, the risk premium of default risk, depends on the choice of credit-risk models.

"Our calibration is done according to the credit ratings of corporate bonds," says Huang. "The advantage of our approach is that, instead of relying on ad hoc choices of model parameters, we rely on empirically observed default rates and loss rates to gauge the level of credit risk of bonds with given credit ratings."

This ensures that the calculated credit spread is commensurate with the level of credit risk that holders of the bonds actually experience.
"We found that credit risk accounts for only a small fraction of the total corporate-Treasury yield spread for investment grade bonds, while it accounts for a much larger fraction of the total spread for junk bonds," says Huang.

For investment grade bonds, credit risk accounts for less fractions of the total corporate-Treasury yield spreads for bonds with shorter maturities. The effects are reversed for junk bonds-credit risk accounts for larger fractions of the total corporate-Treasury yield spreads for bonds with shorter maturities.