Rational Myopia in Credit Markets

22 Pages Posted: 22 Jul 2020

Date Written: July 11, 2020

Abstract

Like equity markets, credit markets seem chronically short-sighted. When debt is serviced regularly, creditors seem to get complacent about the risks. When default shocks them out of complacency, they seem to overreact. Reinhart and Rogoff (2009) contended that sovereign debt markets have been especially prone to understate mounting default risks as long as debts are being serviced.

The main manifestation of myopia is a large jump in credit spreads on news of related default. It is impossible to reconcile such jumps with rational learning about stable risks. However, when risks are not expected to be stable, rational agents will focus disproportionately on recent news, since old news might have ceased to be relevant. When a model of rational learning is fit to historical evidence on corporate and sovereign defaults, markets alternate between long periods of calm with low spreads and shorter periods of turbulence with generally higher spreads. The contrasts are especially sharp for sovereign debt because the relevant pool size is much smaller. While this does not prove that debt markets behave rationally, it shows that extended oscillations in credit spreads, alternation of calm and turbulence, and occasional large jumps do not inherently signal irrationality.

Keywords: bond market, credit spreads, corporate default, sovereign debt default, irrational exuberance, uncertainty, anticipation

JEL Classification: D840, G120, G320, H630

Suggested Citation

Osband, Kent, Rational Myopia in Credit Markets (July 11, 2020). Available at SSRN: https://ssrn.com/abstract=3649122 or http://dx.doi.org/10.2139/ssrn.3649122

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