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Downside risk and the size of credit spreads

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Gemmill, Gordon and Keswani, Aneel. (2011) Downside risk and the size of credit spreads. Journal of Banking & Finance, Vol.35 (No.8). pp. 2021-2036. ISSN 0378-4266

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Official URL: http://dx.doi.org/10.1016/j.jbankfin.2011.01.019

Abstract

We investigate why spreads on corporate bonds are so much larger than expected losses from default. Systematic factors make very little contribution to spreads, even if higher moments or downside effects are taken into account. Instead we find that sizes of spreads are strongly related to idiosyncratic-risk factors: not only to idiosyncratic equity volatility, but even more to idiosyncratic bond volatility and idiosyncratic bond value-at-risk. Idiosyncratic bond volatility helps to explain spreads because it reflects not just the distribution of firm value but is also a proxy for liquidity risk. Idiosyncratic bond value-at-risk adds to this by capturing the left-skewness of the firm-value distribution. We confirm our results both for the initial 1997–2004 sample period and also out of sample for 2005–2009, which includes the sub-prime crisis. Overall, credit spreads are large because they incorporate a large risk premium related to investors’ fears of extreme losses.

Item Type:	Journal Article
Subjects:	H Social Sciences > HG Finance
Divisions:	Faculty of Social Sciences > Warwick Business School
Library of Congress Subject Headings (LCSH):	Corporate bonds, Risk
Journal or Publication Title:	Journal of Banking & Finance
Publisher:	Elsevier Science BV
ISSN:	0378-4266
Date:	August 2011
Volume:	Vol.35
Number:	No.8
Page Range:	pp. 2021-2036
Identification Number:	10.1016/j.jbankfin.2011.01.019
Status:	Peer Reviewed
Publication Status:	Published
Access rights to Published version:	Restricted or Subscription Access
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URI:	http://wrap.warwick.ac.uk/id/eprint/39468