Empirical Studies of Credit Spreads and Ratings

Abstract

The credit markets experienced fundamental changes during the last two decades. Corporate debt volumes have expanded rapidly making such debt one of the largest asset classes in financial markets. Structured credit products revolutionized banking practices and transformed the framework of credit risk management. Credit risk modeling, valuation and rating have, in consequence, been extensively studied. Many issues remain controversial for both academics and industry practitioners, however, especially in the wake of the recent financial crisis. This thesis contributes to the existing literature in four ways. First, a new approach is introduced for jointly estimating rating-specific bond spread term structures. The approach achieves fitting accuracy comparable to the more standard extended Nelson-Siegel technique meanwhile yielding well-behaved and stable term structures which are appropriately ordered for different rating classes. Second, a ‘clinical’ study is presented of the evolution of Asset Backed Security (ABS) valuations conditional on ratings during two crisis periods, namely the 2007-2009 crisis and the earlier collapse of ABS secured against Manufactured Housing loans of 2002-2003. The study focusses on the market’s reactions to different pricing factors in crisis time including liquidity and risk premiums. Third, we examine predictable fluctuations in agency ratings behavior over the business cycle and propose simple, tractable ways of parameterizing time-varying rating transition matrices. Fourth, we examine the dependence of corporate bond market risk premiums on industrial sector. The analysis sheds light on the hypothesis that the cross-sectional pattern of risk premiums reflects the degree to which bond issuers operate in cyclically sensitive industries. By adjusting sectorspecific spreads for time-varying and sector specific expected losses and for liquidity, we show that spreads and, even more so, risk premiums are related to the cyclicality of the obligor’s industry.