Decomposing credit spreads

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 01 March 2005

Working Paper No. 253
By Rohan Churm and Nikolaos Panigirtzoglou

This paper investigates the information contained in the yields of corporate debt securities using a structural credit risk model. As previous studies have found, credit risk is not the only factor that affects corporate yield spreads. The aim is to decompose credit spreads, using a structural model of credit risk, into credit and non-credit risk components. The contribution relative to the existing literature is the use of contemporaneous forward-looking information on equity risk premia and equity value uncertainty in a structural model. In particular, implied equity risk premia from a three-stage dividend discount model that incorporates analysts’ long-term earnings forecasts are used, together with implied measures of equity value uncertainty from option prices. The paper examines the evolution of the different components of spreads across time as well as the effect of particular events. It also analyses the relationship between the derived components and other financial variables, such as swap spreads and the equity risk premium.

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