Credit Spread Decomposition
Abstract: Credit spread decomposition refers to breaking down a bond’s option-adjusted spread to Treasuries into market-wide risk premium, expected default loss, and expected liquidity cost components. Credit spread decomposition is implemented empirically by regressing a bond’s option-adjusted spread on a measure of its expected default losses (credit default swap spread) and expected liquidity cost. Credit spread decomposition can help investors determine the extent to which credit spreads reflect expected default losses, liquidity costs, or a market-wide risk premium. Investors can also apply spread decomposition analysis to construct targeted hedging strategies and to identify relative value opportunities. Regulators can use spread decomposition to monitor separately the liquidity and credit risk of the institutions they supervise, and to help determine capital adequacy.
At issuance, a credit bond has a positive yield spread (i.e., a credit spread) over comparable-maturity Treasury bonds to compensate investors for the chance that the bond may default with a recovery value less than par. However, studies have documented that credit spreads are generally much larger than justified by their subsequent default and recovery experience.1
Beyond expected default losses, a portion of the credit spread may reflect the expected liquidity cost ...