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  5. Determinants of Credit Spreads
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Determinants of Credit Spreads

Paper Session

Monday, Jan. 4, 2021 3:45 PM - 5:45 PM (EST)

Hosted By: American Finance Association
  • Chair: Pierre Collin-Dufresne, Swiss Federal Institute of Technology-Lausanne

Commonality in Credit Spread Changes: Dealer Inventory and Intermediary Distress

Zhiguo He
,
University of Chicago
Paymon Khorrami
,
Imperial College London
Zhaogang Song
,
Johns Hopkins University

Abstract

Two intermediary-based factors – a broad distress measure and a corporate bond inventory measure – explain 50% of the puzzling common variation of credit spread changes beyond canonical structural factors. A simple margin-based model accounts for this co-movement and delivers further implications with empirical support. First, whereas bond sorts on margin-related variables produce monotonic loading patterns on intermediary factors, non-margin-related sorts produce no pattern. Second, dealer inventory co-moves with corporate-credit assets only, whereas intermediary distress co-moves even with non-corporate-credit assets. Third, dealers’ inventory responds to (instrumented) bond sales by institutional investors. Fourth, bond-factor sensitivities flip signs during regulatory tightening.

When Are Financial Covenants Relevant?

Sergei Davydenko
,
University of Toronto
Redouane Elkamhi
,
University of Toronto
Marco Salerno
,
University of Toronto

Abstract

We show that financial covenants may have no value for creditors of highly levered firms, because an attempt to enforce their rights in technical default would result in a lower payoff than waiving the covenant and ceding control to shareholders. This explains the widespread use of cov-lite loans by levered firms. By contrast, for investment-grade firms tightly set covenants allow creditors to demand full repayment while the firm is still solvent. This ensures that creditors sustain no loss regardless of the underlying default probability, mitigating their concerns about the firm's financial health and alleviating adverse selection in lending. We show that the optimal strictness of financial covenants is hump-shaped in the firm's leverage.

Persistent Crises and Levered Asset Prices

Lars Kuehn
,
Carnegie Mellon University
David Schreindorfer
,
Arizona State University
Florian Schulz
,
University of Washington

Abstract

We rationalize the joint behavior of aggregate consumption, asset prices, and financial leverage by incorporating persistent macroeconomic crises into a structural credit risk model. As in the data, longer-lasting crises are associated with more severe macroeconomic contractions and larger increases in leverage ratios, credit risk, and return volatility. Leverage provides a strong propagation mechanism for fundamental shocks because it continues to rise while crises endure. The model replicates the firm-level implied volatility curve and its cross-sectional relation with observable proxies of default risk. Lastly, a structural estimation reveals that common idiosyncratic risk is an important driver of credit spreads.

Feedback and Contagion through Distressed Competition

Hui Chen
,
Massachusetts Institute of Technology
Winston Wei Dou
,
University of Pennsylvania
Hongye Guo
,
University of Pennsylvania
Yan Ji
,
Hong Kong University of Science and Technology

Abstract

Firms tend to compete more aggressively in financial distress; the intensified competition in turn reduces profit margins for everyone, pushing some further into distress. To study such feedback and contagion effects, we incorporate dynamic strategic competition into an industry equilibrium with long-term defaultable debt, which generates various peer interactions: predation, self-defense, and collaboration. Such interactions make cash flows, stock returns, and credit spreads interdependent across firms. Moreover, industries with higher idiosyncratic-jump risks are more distressed, yet also endogenously less exposed to aggregate shocks. Finally, we exploit exogenous variations in market structure -- large tariff cuts -- to test the core competition mechanism.
Discussant(s)
Antje Berndt
,
Australian National University
Erwan Morellec
,
Swiss Federal Institute of Technology-Lausanne
Anders B. Trolle
,
HEC Paris
Francesca Zucchi
,
Federal Reserve Board
JEL Classifications
  • G1 - Asset Markets and Pricing