How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk?

Abstract:     
No consensus has yet emerged from the existing credit risk literature on how much of the observed corporate-Treasury yield spreads can be explained by credit risk. In this paper, we propose a new calibration approach based on historical default data and show that one can indeed obtain consistent estimate of the credit spread across many different economic considerations within the structural framework of credit risk valuation. We find that credit risk accounts for only a small fraction of the observed corporate-Treasury yield spreads for investment grade bonds of all maturities, with the fraction smaller for bonds of shorter maturities; and that it accounts for a much higher fraction of yield spreads for junk bonds. We obtain these results by calibrating each of the models - both existing and new ones - to be consistent with data on historical default loss experience. Different structural models, which in theory can still generate a very large range of credit spreads, are shown to predict fairly similar credit spreads under empirically reasonable parameter choices, resulting in the robustness of our conclusion.

Number of Pages in PDF File: 70

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