Empirical Credit Risk

Jun 1, 2003

We describe an empirically motivated model of credit risk based on a study of the relation between returns to corporate bonds, government bonds and equities.  Examining almost 200,000 monthly return events spanning 6+ years, we find a clear systematic relationship between issuer credit quality, as measured by its bonds' yield spreads, an the attribution of its bonds' return to interest rate changes and the issuer's equity return.  Returns to high quality bond, with low yield spreads, are largely explained by interest rate changes, while returns to low qualitybonds, with large spreads are primarily explained by the issuer's equity returns.  Returns tobonds of intermediate credit quality are not significantly explained by either interest rate changes or equity returns, and appear to be attributable only tobond market specific factors. ("Explained" here does not imply causation, but merely dependence in a regression.)  We also find evidence of an agency effect in the weaker correlatoins betweenbond returns and positive firm-specific equity returns than between bond returns and equity common-factor returns or between bond returns or between bond returns and negative firm-specific equity returns.  Using a heuristic model giving the regression coefficients of the bond return relationship in terms of the leven of bond spreads, we describe an improved approach to modeling credit risk for corporate bonds, effectively accounting for correlations induced by market common factors.