The Global Credit Spread Puzzle

Abstract

Using security-level credit spread data in eight developed economies, we document a large cross-country difference in credit spreads conditional on credit ratings and other default risk measures. The standard structural models not only fail to explain this cross-country variation in spreads but also have difficulty predicting credit spreads accurately. We implement an extended structural model that incorporates endogenous liquidity in the secondary market and find that this model largely explains credit spreads in the cross section and over time, as well as significantly reduces pricing errors. Therefore, default risk itself is an unlikely explanation for international corporate bond spreads.

Keywords: Corporate credit spreads, Credit spread puzzle, Structural credit risk models, Merton model, Black and Cox model, CDS, Fixed income asset pricing

JEL Classification: G12, G13