Using dealer’s quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross-correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply0 demand shocks that are independent of both credit-risk factors and standard proxies for liquidity.

Abstract not found

This paper explores the e¡ect of equity volatility on corporate bond yields. Panel data for the late 1990s show that idiosyncratic ¢rm-level volatility can explain as much cross-sectional variation in yields as can credit ratings. This ¢nding, together with the upward trend in idiosyncratic equity volatility documented by Campbell, Lettau, Malkiel, and Xu (2001), helps to explain recent increases in corporate bond yields. DURING THE LATE 1990s, THE U.S. EQUITY and corporate bond markets behaved very di¡erently. As displayed in Figure 1, stock prices rose strongly, while at the same time, corporate bonds performed poorly. The proximate cause of the low returns on corporate bonds was a tendency for the yields on both seasoned and newly issued corporate bonds to increase relative to the yields of U.S.Treasury securities. These increases in corporate^Treasury yield spreads are striking because they occurred at a time when stock prices were rising; the optimism of stock market investors did not seem to be shared by investors in the corporate bond market.

This is the first study that computes default measures for individual firms using Merton’s (1974) option pricing model, to assess the effect that default risk has on equity returns. We find that equally-weighted portfolios of stocks with high default probability earn significantly higher returns than equally-weighted portfolio of stocks with low default probability. In addition, both the size and book-to-market effects are present only within the portfolio of stocks with the highest default probabilities. Once stocks with the 30 % highest default probabilities are excluded from the sample, both size and B/M effects disappear. We also find that default risk is priced and can explain part of the cross-sectional variation in returns. The Fama-French factors SMB and HML, and particularly SMB, contain some default-related information, although it appears that this information is not the driving force behind the success of the Fama-French model. Keywords: default risk, equity returns, Merton’s (1974) model, size and book-to-market. JEL classification: G33, G12 1

wish to thank Andre Haris, Lozan Bakayatov, and Davron Yakubov for their excellent data collection efforts. In addition, we thank the financial assistance of the Social Sciences and Humanities Research Council of Canada. All errors remain the responsibility of the authors. Corporate Yield Spreads and Bond Liquidity We examine whether liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4000 corporate bonds and spanning investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads; and that an improvement of liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers ’ fixed effect and potential endogeneity bias. Our finding mitigates the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants, and suggests that liquidity plays an important role in corporate bond valuation.

The “shadow banking system, ” at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent. Unlike the historical banking panics of the 19 th and early 20 th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms “running ” on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin (“haircut”), forcing massive deleveraging, and resulting in the banking system being insolvent. The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic. + This paper draws on a number of current research projects with several coauthors. I acknowledge their influences on my thinking and thank them: Tri Vi Dang, Bengt Holmström, and Andrew Metrick. In particular, I thank Bengt Holmström for reminding me of the relevance of my own work with George Pennacchi when he discussed Gorton (2008). For help with data I thank Craig Furfine, Richard Grossman and various participants in the capital markets. Thanks to James Aitken, David Andolfatto, Charles

This paper introduces measures of volatility and jump risk that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain important information for credit spreads and improve on both implied volatilities of index options and on historical volatilities when explaining the crosssectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and the implied-volatility skew matter for credit spreads. The empirical estimates are in line with the coefficients predicted by a theoretical structural firm value model. Importantly, detailed principal component analysis shows that our newly constructed determinants of credit spreads reverse the finding in the literature that structural models leave a large part of the variation in credit spreads unexplained. Furthermore, our results indicate that option-market liquidity has a spillover effect on the short-maturity corporate bond market, and we show that individual option prices contain information on the likelihood of rating migrations.

Abstract not found

This paper provides new evidence on the empirical success of structural models in explaining corporate credit risk changes. A parsimonious set of common factors and firm-level fundamentals, inspired by structural models, explains more than 54 % (67%) of the variation in credit spread changes for medium (low) grade bonds. No dominant latent factor is present in the unexplained variation. While our set of variables has lower explanatory power among high-grade bonds, it does capture most of the systematic variation of credit-spread changes in that category as well. It also subsumes the explanatory power of the Fama and French (1993) factors among all grade classes. This paper assesses the success of structural models in empirical studies of changes in corporate credit spreads. Our focus is set on the change in the credit spread, not its level. 1 The difference in studying credit spreads vs. changes in credit spreads is equiv-alent to the difference in studying equity prices vs. equity expected returns. Indeed, there is a one-to-one correspondence between the spread level and the bond price, while

Michigan State University, and the University of New Orleans for their helpful comments. Sincere thanks