Stressed Distance to Default and Default Risk

Abstract

Distance to default (DTD) is a strong predictor of default risk. In this paper, we propose a stressed version of DTD (“stressed DTD”) to measure time-varying corporate default risk in the event that a systematic stress scenario occurs. We show that the stressed
DTD is a better predictor of corporate defaults during the 2007–2009 crisis compared with the regular DTD, the Campbell et al. (2008) measure of probability of default, and the systematic default risk measure (“failure beta”) of Hilscher and Wilson (2017). Controlling
for raw default probability and failure beta, we show that the stressed DTD can explain variations in both credit default swap spreads and credit ratings. Our results provide evidence that investors require compensation for exposure to stressed default risk, and provide a rationale for considering credit stability under stress in ratings.

Keywords: Default risk; Distance to default; Stress testing; Credit default swap; Credit rating

JEL Classification: G01; G20; G32; G33