What Drives Corporate Bond Risk Premia? Evidence from the CDS Market

Posted: 18 Mar 2011 Last revised: 21 Oct 2017

See all articles by Antonio Diaz

Antonio Diaz

University of Castilla-La Mancha

Jonatan Groba

Strategic Link

Pedro Serrano

University Carlos III of Madrid - Department of Business Administration

Date Written: October 1, 2013

Abstract

This article studies the economic factors behind corporate default risk premia in Europe during the period 2006–2010. We employ information embedded in Credit Default Swap (CDS) contracts to quantify expected excess returns from the underlying bonds in market-wide default circumstances. We disentangle the compensation to investors for unexpected changes in the creditworthiness of the bond issuer from their remuneration for the risk that the bond's price will drop in the event of default. Our results show that the risk premia associated with systematic factors influencing default arrivals represent approximately 40% of total CDS spread (on median). These premia also exhibit a strong source of commonality; a single principal component explains approximately 88% of their joint variability. This factor significantly covaries with aggregate illiquidity and sovereign risk variables. Empirical evidence suggests a public-to-private risk transfer between sovereign credit spread and corporate risk premia. Finally, the compensation in the event of default is approximately 14 basis points of the total CDS spread, and a significant amount of jump-at-default risk may not be diversifiable.

Keywords: Credit Default Swap, Distress Risk Premium, Expected Default Frequency, Jump-At-Default Risk Premium

JEL Classification: G12, G13, G32, F30

Suggested Citation

Diaz Perez, Antonio and Groba, Jonatan and Serrano, Pedro, What Drives Corporate Bond Risk Premia? Evidence from the CDS Market (October 1, 2013). Journal of International Money and Finance, Vol. 37, 2013. Available at SSRN: https://ssrn.com/abstract=1787316 or http://dx.doi.org/10.2139/ssrn.1787316

Antonio Diaz Perez

University of Castilla-La Mancha ( email )

Plaza Universidad, 1
Albacete, Albacete 02071
Spain

Jonatan Groba

Strategic Link

Kennesaw, GA 30144
United States

Pedro Serrano (Contact Author)

University Carlos III of Madrid - Department of Business Administration ( email )

C/ Madrid, 126
Getafe, Madrid 28903
Spain
+34916248926 (Phone)

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