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The Effects of Default Correlation on Corporate Bond Credit Spreads

by Bill Bobey of Saint Mary's University

November 2009

Abstract: The tendency for firms' defaults to cluster is a widely accepted phenomenon in corporate bond and credit derivatives markets. In this paper, I analyse the relationship between systematic default correlation and corporate bond credit spreads. I show that credit spreads are positively related to CDO market implied default correlation and that this holds using either a model implied measure of default correlation or the spread between a CDO's equity and super-senior tranches. Using monthly data spanning January 2004 to September 2008, I show that a one basis point decrease in the CDO tranche spread-of-spreads translates into a 0.91 basis point increase in 5-year credit spreads and a 0.94 basis point increase in 10-year credit spreads; this after controlling for the risk-free term structure of interest rates, equity market returns and volatility, and firm effects. In addition, I perform principal component analysis on the regression residuals and find little evidence of a missing systematic factor.

JEL Classification: G12, G13.

Keywords: Credit spreads, default clustering, default correlation, collateralized debt obligations, implied hazard rate density, contagion.

Previously titled: Contagion: The Effects of Default Correlation and Firm Characteristics on Credit Spreads

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