Long Run Credit Risk Diversification: Empirical Decomposition of Corporate Bond

Review of Securities and Futures Markets, Vol. 20, No. 2, 2008

Posted: 23 Jan 2010 Last revised: 27 Jan 2010

See all articles by David S. Sun

David S. Sun

Kainan University

William T. LIn

Tamkang University - Banking & Finance

Chien Chung Nieh

Tamkang University

Date Written: June 15, 2008

Abstract

Following the reduced-form models of Duffee (1999) and Jarrow, Lando and Yu (2005), this study investigates the risk diversification issue of corporate bond portfolios. Considering especially long run market behavior, our empirical decomposition of corporate bond yield spreads indicates that the idiosyncratic component serves as a good vehicle for risk diversification. Moreover, the idiosyncratic spread provides significant inferences about observed conditional corporate bond default rate, while full spread does not. Applying an affine model from Duffie and Singleton (1999), we find that the idiosyncratic credit spreads do not respond empirically to Treasury yields, unlike what is suggested in the structural model of Longstaff and Schwartz (1995) and literatures that follow. Systematic credit spreads are however positively related to Treasury yields in the long-run, but negatively so in the short run, suggesting the validity of both the tax and the option hypotheses. A long-run and optimal decomposition scheme yields an idiosyncratic credit spread measure at a median of 60 b.p.

Keywords: bond pricing, cointegration, credit risk, credit spread, diversifiable risk

JEL Classification: C32, E4, G13, G33

Suggested Citation

Sun, David S. and LIn, William T. and Nieh, Chien Chung, Long Run Credit Risk Diversification: Empirical Decomposition of Corporate Bond (June 15, 2008). Review of Securities and Futures Markets, Vol. 20, No. 2, 2008, Available at SSRN: https://ssrn.com/abstract=1540926

David S. Sun (Contact Author)

Kainan University ( email )

No. 1, Kāinán Rd
Taoyuan, Taiwan
Taiwan

William T. LIn

Tamkang University - Banking & Finance ( email )

Department of Banking and Finance
Taiwan, 25137
Taiwan

Chien Chung Nieh

Tamkang University ( email )

Department of Banking and Finance
Taiwan, 25137
Taiwan

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