Default Risk, Default Risk Premiums, and Corporate Yield Spreads

Abstract

An important research area of the corporate yield spread literature seeks to measure the proportion of the spread explained by various factors such as the possibility of default, liquidity or tax differentials. We contribute to this literature by assessing the ability of observed macroeconomic factors and the possibility of changes in regimes to explain the default risk proportion in yield spreads. For this purpose, we extend the Markov Switching risk-free term structure model of Bansal and Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond prices. The model is calibrated with consumption, inflation, risk-free yield and default data over the 1987-1996 period. Preliminary results show that up to 64% of the ten years corporate yield spread for industrial Baa is explained by the possibility of default.

Keywords: Corporate yield spread, default risk, default risk premium, credit spread level puzzle, macroeconomic risk premium

JEL Classification: G11, G12, G13, G21, G23