The Risk Microstructure of Corporate Bonds: A Case Study from the German Corporate Bond Market

Abstract

This article presents joint econometric analysis of interest rate risk, issuer-specific risk (credit risk) and bond-specific risk (liquidity risk) in a Lando (1998) type model within the Duffie/Singleton framework. Our model accomodates correlation between interest rate risk and issuer-specific risk, but nevertheless admits sequential estimation of the risk-free term structure parameters and the issuer-specific and bond-specific components. By means of data augmentation and exact Bayesian analysis we develop a framework to estimate the model parameters and to separate the different components of risk. In particular we do not require an arbitrary benchmark bond that is free of any bond-specific risk. Our methodology infers a risk-free term structure process from liquid swap market data. Based on these estimates, issuer-specific and bond-specific risk are estimated from corporate bond data. The estimation procedure is applied to coupon bond data from the German corporate bond market.

In addition, we look for the determinants of issuer and bond specific spreads. Regarding liquidity and credit risk, literature has suggested several proxies. Popular examples are issue size, time to maturity, age and number of active trading days (see e.g. Fisher (1959), Sarig/Warga (1989), Amihud/Mendelson (1991), Warga (1992), Crabbe/Turnber (1995), Kempf/Uhrig-Homburg (2000) or Houweling et al. (2003)) or the KMV distance to default and the debt to value ratio. Our methodology enables us to verify which of these proxies are the most appropriate.

Keywords: Credit risk, Liquidity risk, Duffie/Singleton framework, Markov Chain Monte Carlo estimation, Density approximation

JEL Classification: C52, G12, B13, E43