Time Varying Default Risk Premia in Corporate Bond Markets

Abstract

We develop a methodology to study the linkages between equity and corporate bond risk premia and apply it to a large panel of corporate bond transaction data. We and that a significant part of the time variation in bond default risk premia can be explained by equity implied bond risk premium estimates. We compute these estimates using a recent structural credit risk model. In addition, we show by means of linear regressions that augmenting the set of variables predicted by typical structural models with equity-implied bond default risk premia significantly increases explanatory power. This in turn suggests that time varying risk premia are a desirable feature for future structural models.

Keywords: corporate bonds, credit risk, structural model, volatility, default risk premia, idiosyncratic risk

JEL Classification: G12, G13