The credit spread puzzle

Jeffery D Amato and Eli Remolona

BIS Quarterly Review, 2003

Abstract: Why are spreads on corporate bonds much wider than would be implied by expected losses from default? Previous explanations of this puzzle have assumed that investors can diversify away the risk that actual losses in a corporate bond portfolio will exceed expected losses. However, the skewness in the distribution of corporate bond returns implies that achieving such diversification will require an extraordinarily large portfolio. We present evidence from the market for collateralised debt obligations suggesting that such large portfolios are unattainable. Hence, investors always face the risk that actual losses will exceed expectations. Credit spreads are so wide because they compensate investors for such risk.

JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2003
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Citations: View citations in EconPapers (92)

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