Default correlation: rating, industry ripple effect, and business cycle

Howard Qi, Jian Shi and Yan Alice Xie

Applied Economics, 2019, vol. 51, issue 30, 3256-3273

Abstract: For a well-diversified bond portfolio, default risk over the investment horizon is known as the major risk and the risk is largely from correlated defaults. While plenty of theoretical work about default correlation has been developed, empirical studies on default correlation have not made much progress in the past two decades. In this paper, we fill this void in the literature by thoroughly investigating how default correlation changes across different bond ratings, over different time horizons, and across different industries over the sample period of 1970 to 2014. In particular, we examine how rating-based default correlations change before, during, and after recessions. More importantly, we reveal the ‘industry ripple effect’ that default correlations are low within upstream industries but become higher within downstream industries along the structure of the supply chain. Also, default correlations are relatively high between upstream industries and downstream industries.

Date: 2019
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DOI: 10.1080/00036846.2019.1566689

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