Default Risk in Corporate Yield Spreads

Abstract

An important research question examined in the credit risk literature focuses on the proportion of corporate yield spreads attributed to default risk. This topic is reexamined in the light of the different issues associated with the computation of transition and default probabilities obtained from historical default data. We find that the out of sample estimated default risk proportion in corporate yield spreads is highly sensitive to the ex-ante estimated term structure of default probabilities used as inputs. This proportion can become a large fraction of the yield spread when sensitivity analyses are made with respect to the period over which the probabilities are estimated and the recovery rates. The computation of approximate confidence sets evaluates the statistical precision of the estimated proportions which are also shown to be sensitive to the different filtering procedures required to treat the historical default data base.

Keywords: Corporate yield spread, default risk, estimation period, generator, recovery rate, data filtration, confidence intervals

JEL Classification: G21, G32, G33