US Corporate Bond Yield Spread : A default risk debate

TL;DR

This paper empirically investigates the role of default risk in US corporate bond yield spreads, finding that nearly half of the spread variation is due to default risk, especially during the 2007-2009 financial crisis.

Contribution

It introduces an efficient default risk indicator using the Lubotsky & Wittenberg method, addressing measurement issues in prior empirical studies.

Findings

48% of yield spread variation explained by default risk

Default risk's importance increased during the 2007-2009 crisis

Highlights problems with ad-hoc measurement methods in literature

Abstract

According to theoretical models of valuing risky corporate securities, risk of default is primary component in overall yield spread. However, sizable empirical literature considers it otherwise by giving more importance to non-default risk factors. Current study empirically attempts to provide relative solution to this conundrum by presuming that problem lies in the subjective empirical treatment of default risk. By using post-hoc estimator approach of Lubotsky & Wittenberg (2006), we construct an efficient indicator for risk of default, by using sample of 252 US non-financial corporate data (2000-2010). On average, our results validate that almost 48% of change in yield spread is explained by default risk especially in recent financial crisis period (2007-2009). Hence, our results relatively suggest that potential problem lies in the ad-hoc measurement methods used in existing empirical literature.