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| The Effects of Default Correlation on Corporate Bond Credit Spreads by Bill Bobey of the University of Toronto November 2007 Abstract: The tendency for firms' defaults to cluster, although a widely accepted phenomena in bond and credit derivatives markets, has yet to be related to corporate bond credit spreads. Default clustering indicates periods of increased default risk and highly correlated defaults, and therefore, it should be positively related with credit spreads. To test this I introduce a new systematic component to credit spreads, a measure of default correlation that is implied from collateralized debt obligation market spreads, and I find strong evidence supporting the prediction. I also find evidence that credit spread changes with respect to default correlation are decreasing in firm size and diversity. This is consistent with contagion wherein a large diversified firm's credit event is more likely to induce credit events in other firms than is a small non-diversified firm's credit event. In addition, I find the explained variation in credit spreads is predominately due to firm characteristics and report limited evidence of a missing common factor in the unexplained variation. In presenting the new systematic factor, I outline key features of CDOs and explain default correlation's role in their valuation. Keywords: Credit spreads, default clustering, default correlation, collateralized debt obligations, implied hazard rate density, contagion. Previously titled: Contagion: The Effects of Default Correlation and Firm Characteristics on Credit Spreads Download paper (520K PDF) 56 pages Related reading: A Comparative Empirical Study of Asset Correlations
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