Reduced-form models of default calibrated to expected default losses and comovements between default losses and an equity-based pricing kernel generate CDS spreads that tend to fall below historical values. In frictionless markets, resolving this credit spread puzzle requires credit-market investors, especially those in high-quality debt, to be more risk adverse than equity-market investors. In the absence of market segmentation, however, the puzzle points to a liquidity component that, depending on themodel specification, can account for more than half of historical CDS spreads. These findings caution against fitting reduced-formmodels to CDS spreads without accounting for market segmentation or frictions. (JEL G12, G13, G22, G24) It has been a long-standing puzzle that structural credit riskmodels calibrated to historical default and recovery rates produce investment-grade (IG) cor-porate bond yield spreads that are below historical values. While structural models offer much needed economic content to credit risk modeling, this credit spread puzzle cautions against their unconditional use. Reduced-form credit risk models, on the other hand, offer less economic content but

[We establish Markovian models in the Heath, Jarrow, and Morton (1992) paradigm that permit an exponential affine representation of riskless and risky bond prices while offering significant flexibility in the choice of volatility structures. Estimating models in our family is typically no more difficult than in the workhorse affine family. Besides diffusive and jump-induced default correlations, defaults can impact the credit spreads of surviving firms, allowing for a greater clustering of defaults. Numerical implementations highlight the importance of incorporating interest rate-credit spread correlations, credit spread impact factors, and the full credit spread curve when building a unified framework for pricing credit derivatives.]

Nearly half of the variation in European CDS returns is captured by a novel factor that mimics economic catastrophe risk. During the financial crisis of 2007–8, this factor became more important relative to other sources of risk, leading to a shift in the correlation structure of CDS returns. Using equivalent CDS and equity portfolios, we show that while crucial for explaining temporal and cross-sectional variation in CDS returns, the factor plays a lesser role for equity. This is likely due to the limited sensitivity of the equity value at default to whether the event is of systemic or idiosyncratic nature.

We measure credit risk premia—prices for bearing corporate default risk in excess of expected default losses—using Markit CDS and Moody’s Analytics EDF data. We find dramatic variation over time in credit risk premia, with peaks in 2002, during the global financial crisis of 2008–09, and in the second half of 2011. Even after normalizing these premia by expected default losses, median credit risk premia fluctuate over time by more than a factor of 10. Credit risk premia comove with macroeconomic indicators, even after controlling for variation in expected default losses, with higher premia per unit of expected loss during times of market-wide distress. Countercyclical variation of premia-to-expected-loss ratios is more pronounced for investment-grade issuers than for high-yield issuers.

We establish Markovian models in the Heath, Jarrow, and Morton (1992) paradigm that permit an exponential affine representation of riskless and risky bond prices while offering significant flexibility in the choice of volatility structures. Estimating models in our family is typically no more difficult than in the workhorse affine family. Besides diffusive and jump-induced default correlations, defaults can impact the credit spreads of surviving firms, allowing for a greater clustering of defaults. Numerical implementations highlight the importance of incorporating interest rate--credit spread correlations, credit spread impact factors, and the full credit spread curve when building a unified framework for pricing credit derivatives. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

For globally systemically important banks (GSIBs) with US headquarters, we find significant reductions in market-implied probabilities of government bailout after the Global Financial Crisis (GFC), along with roughly 170 percent higher wholesale debt financing costs for these banks after controlling for insolvency risk. Since the GFC, bank creditors appear to expect much larger losses in the event that a GSIB approaches insolvency. In this sense, we estimate a decline of “too big to fail.” (G01, G12, G21, G28, G33, H81)