The Global Credit Spread Puzzle

Abstract

Using security-level credit spread data in eight developed economies, we show that the standard structural models underpredict credit spreads. The models fail to generate the distribution of credit spreads at the bond level accurately, explain the cross-country difference in spreads, and match the time-series variation in bond yields. In contrast, an extended structural model that incorporates endogenous liquidity in the secondary market largely explains credit spreads in the cross section and over time. Therefore, default risk itself is an unlikely explanation for international corporate bond spreads.

Keywords: Corporate credit spreads, Credit spread puzzle, Structural credit risk models, Endogenous Liquidity, Search, Credit default swaps, Fixed income asset pricing

JEL Classification: G12, G13