How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk?

Abstract

We show that credit risk accounts for only a small fraction of the observed corporate-Treasury yield spreads for investment grade bonds of all maturities, with the fraction smaller for bonds of shorter maturities; and that it accounds for a much higher fraction of yield spreads for junk bonds. This conclusion is shown to be robust across a wide class of structural models-both existing and new ones-that incorporate many different economic considerations. We obtain such consistent results by calibrating each of the models to be consistent with data on historical default loss experience. Different models, which in theory can still generate a very large range of credit risk premia, are shown to predict fairly similar credit risk premia under empirically reasonable parameter choices, resulting in the robustness of our conclusions.