The Credit Spread Puzzle

Spreads on corporate bonds tend to be many times wider than what would be implied by expected default losses alone. These spreads are the difference between yields on corporate debt subject to default risk and government bonds free of such risk.2 While credit spreads are often generally understood as the compensation for credit risk, it has been difficult to explain the precise relationship between spreads and such risk. In 1997–2003, for example, the average spread on BBB-rated corporate bonds with three to five years to maturity was about 170 basis points at annual rates. Yet, during the same period, the average yearly loss from default amounted to only 20 basis points.In this case, the spread was more than eight times the expected loss from default. The wide gap between spreads and expected default losses is what we call the credit spread puzzle. In this article we argue that the answer to the credit spread puzzle might lie in the difficulty of diversifying default risk. Most studies to date have implicitly assumed that investors can diversify away the unexpected losses in a corporate bond portfolio. However, the nature of default risk is such that the distribution of returns on corporate bonds is highly negatively skewed. Such skewness would require an extraordinarily large portfolio to achieve full diversification. Evidence from the market for collateralised debt obligations (CDOs) indicates that in practice such large portfolios are unattainable, and thus unexpected losses are unavoidable. Hence, we argue that spreads are so wide because they are pricing undiversified credit risk. We first review the existing evidence on the determinants of credit spreads, including the role of taxes, risk premia and liquidity premia. We then discuss the role of unexpected losses and the difficulties involved in diversifying credit portfolios, drawing on evidence from the CDO market