The Determinants of Yield Spreads and the Market Discipline of Banks
44 Pages Posted: 1 Mar 2009
Date Written: February 28, 2009
Determinants of yield spreads vary with market conditions and available information, which has implications for debt pricing models. After the bailout of Long Term Capital Management (LTCM) in September 1998, important firm-specific default risk measures, such as leverage, are not significant factors in determining yield spread levels of bank-issued subordinated notes and debentures (SND) because these measures do not reflect the true risk of the firm. Bond markets impound a higher cost for higher risk-taking, particularly for off-balance sheet risks, based on return-on-assets, after the LTCM bailout, Yield spreads have become less sensitive to firm-specific risks, even prior to the LTCM bailout, after the issuance of trust-preferred securities (TPS) by banks because TPS are junior claims to SND and provide an additional buffer to SND from default risk. Yield spreads on SND prior to TPS issuance by banks and the LTCM bailout are sensitive to conventional firm-specific risk measures. Yield spreads on TPS at the time of offer provide market signals about on-balance sheet risks.
Keywords: Yield Spread, Default risk, Market Discipline of banks, Market monitoring, Credit risk
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