Pricing Corporate Bonds with Credit Risk Primitives

81 Pages Posted: 9 May 2024

Date Written: May 9, 2024

Abstract

This paper introduces a novel corporate bond risk factor exploiting the interaction between credit spreads and bond duration, generating a large risk-premium even after controlling for market risk and transaction costs. We propose a parsimonious three-factor model incorporating this factor alongside the Treasury and corporate bond market factors, outperforming more complex multi-factor models. The new factor is driven by default news and risk premium news. The factor falls when defaults unexpectedly rise and when the market risk premium falls, providing a unified explanation for the various corporate bond anomalies associated with tail and credit risk.

Keywords: Corporate Bonds, Factor Model, Fixed-Income Securities, Credit Risk

JEL Classification: G12, G13

Suggested Citation

Dickerson, Alexander and Nozawa, Yoshio, Pricing Corporate Bonds with Credit Risk Primitives (May 9, 2024). Available at SSRN: https://ssrn.com/abstract=4822379 or http://dx.doi.org/10.2139/ssrn.4822379

Alexander Dickerson

UNSW Business School ( email )

UNSW Business School
High St
Sydney, NSW 2052
Australia

Yoshio Nozawa (Contact Author)

University of Toronto ( email )

105 St George St
Toronto, ON M5S3E6
Canada
3013125569 (Phone)

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