Modelling European Credit Spreads

by Jan Annaert of the Erasmus University Rotterdam & University of Antwerp, and
Marc J. K. De Ceuster University of Antwerp – UFSIA

September 1999

Introduction: In order to be attractive to investors, risky bonds should offer higher yields than comparable risk-free bonds, to compensate them for the probability of losing (part of) their invested funds. Consequently, a risky bond trades at a lower price than a risk free bond (given an identical maturity and coupon rate). The difference between the yield on the risky bond (‘risky yield', YTM) and the yield of the comparable risk-free bond (‘risk-free yield', i) is called the credit spread (sp).

The spread should at least compensate investors for the expected losses on the risky bond, but –to the extent that investors are risk averse– should also include a risk premium to reward investors for accepting the risk to assume higher than expected losses.

The credit spread may therefore exhibit continuous changes as well as sudden jumps. The jump part is due to credit migration and actual default, whereas continuous changes can be attributed to continuous changes in credit quality and variations in risk premia.

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