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Default Risk in Corporate Yield Spreads

by Georges Dionne of HEC Montréal,
Geneviève Gauthier of HEC Montréal,
Khemais Hammami of HEC Montréal,
Mathieu Maurice of HEC Montréal, and
Jean-Guy Simonato of HEC Montréal

January 2009

Abstract: An important research question examined in the recent credit risk literature focuses on the proportion of corporate yield spreads which can be attributed to default risk. Past studies have verified that only a small fraction of the spreads can be explained by default risk. In this paper, we reexamine this topic in the light of the different issues associated with the computation of transition and default probabilities obtained with historical rating transition data. One significant finding of our research is that the estimated default-risk proportion of corporate yield spreads is highly sensitive to the term structure of the default probabilities estimated for each rating class. Moreover, this proportion can become a large fraction of the yield spread when sensitivity analyses are made with respect to recovery rates, default cycles in the economy, and information considered in the historical rating transition data.

Keywords: Credit risk, default risk, corporate yield spread, transition matrix, default probability, Moody's, Standard and Poor's, recovery rate, data filtration, default cycle.

Published in: Financial Management, Vol. 39, No. 2, (Summer 2010), pp. 707-731.

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