The Credit Spread Puzzle - Evidence from a Quasi-Natural Experiment

Abstract

Prior literature mostly finds bond yield spreads to be insufficiently explained by credit risk in structural models (the 'credit spread puzzle'). In contrast, several recent results consider credit spreads to consist of credit risk to a substantially larger extent (if not even entirely). We address this dissent in the literature using a different empirical methodology. We utilize the removal of sovereign guarantees for savings banks and state banks in Germany as a unique quasi-natural experiment allowing identification of the credit risk component. During a transition period of over ten years, bonds of the same issuer with and without credit risk could be directly compared. Interestingly, less than 20% of the yield spread is due to credit risk for these bonds.

Keywords: Credit spread puzzle, credit risk, sovereign guarantees, quasi-natural experiment.

JEL Classification: G12, G28, G21