JOURNAL13v06 16-02-2005 11:17 Pagina 131

The credit spread puzzle1

John Hull, Professor of Finance, Director, Bonham Centre for Finance
and Maple Financial Group Chair in Derivatives and Risk Management,
Rotman School of Management, University of Toronto
Mirela Predescu, PhD. Candidate in Finance,
Rotman School of Management, University of Toronto
Alan White, Peter L. Mitchelson/SIT Investment Associates Foundation
Chair in Investment Strategy and Professor of Finance,
Rotman School of Management, University of Toronto

Estimation of default probabilities is becoming increasingly are sometimes referred to as ‘real-world default probabilities’
important in risk management. A new regulatory framework or ‘physical default probabilities’.
for banks, Basel II, is expected to be implemented in 2007. This
gives banks much more freedom than its predecessor, Basel I, To estimate the default probability implied by bond prices we
to use internal models to estimate default probabilities. The first calculated the average spread over the risk-free rate for
estimation of default probabilities is also important in the val- a seven year corporate bond. We used the Merrill Lynch bond
uation of credit derivatives, the market for which is growing indices between December 1996 and July 2004. Consider, for
fast. Most credit derivatives provide payoffs contingent on example, A-rated bonds. The average yield on bonds with a
whether particular companies default on their obligations. The life of approximately seven years was 6.274% per annum. The
estimation of default probabilities is therefore central to the average risk-free rate was 5.505% per annum. The average
evaluation of credit derivatives. credit spread was therefore 0.769% per annum. The credit
spread is an indicator of the probability of default. We receive
One approach to estimating default probabilities involves an extra 0.769% per year in additional bond yield because we
looking at historical data and assuming that the future will in expect to lose about 0.769% of the principal per year due to
some sense be similar to the past. Another involves implying defaults.
default probabilities from corporate bond yields. It turns out
that the two approaches give quite different estimates. Our The probability of default is greater than the credit spread
objective in this article is to quantify just how different the because some recovery is made in the event of a default. We
estimates are and then to provide possible reasons for the suppose a recovery rate of 40% (which is fairly close to the
difference. average of the recovery rates observed in practice). This
means that for A-rated bonds the probability of default
Default probability estimates implied by bond prices is 0.769% / (1 - 0.4) or about 1.28% per
Figure 1 shows estimates of the average probability of default annum. To look at this another way, when the average proba-
per year during a seven-year period calculated from histori-
cal data and bond prices. The historical data are cumulative
Rating Default Default Ratio Difference
default rates published by Moody’s for the period between probabilities probabilities
1970 and 2003. This data give the probability of a company from historical implied from
data bond prices
default during a seven-year period given that it has a partic- (% per year) (% per year)
ular credit rating at the beginning of the period. For example,
Aaa 0.04 0.67 16.8 0.63
a company that starts with an Aaa credit rating has an aver- Aa 0.06 0.78 13.0 0.72
age default probability per year of 0.04% (or about 0.28% A 0.13 1.28 9.8 1.15
Baa 0.47 2.38 5.1 1.91
over the whole seven year period). A company that starts Ba 2.40 5.07 2.1 2.67
with a credit rating of Aa has an average default probability B 7.49 9.02 1.2 1.53
Caa and lower 16.90 21.30 1.3 4.40
of 0.06% per year (or about 0.42% over the whole seven-
year period). Default probabilities implied from historical data Figure 1: Average default probabilities per year over a seven-year period

1 The ideas in this paper will be published in a paper by the authors entitled “Credit
Spreads, Default Probabilities, and Risk Premiums” in Journal of Credit Risk. We 131
are grateful to Moody’s Investors Service for supporting this research.
JOURNAL13v06 16-02-2005 11:17 Pagina 132
bility of default is 1.28% per year the loss of principal per year
is 1.28% x (1 – 0.4) or 0.769%, which is the credit spread
earned. Default probabilities backed out from bond prices in
this way are known as ‘risk-neutral default probabilities’.
Figure 1 shows that the ratio of the default probability esti-
mates derived from bond prices to those derived from histori-
cal data decreases as the credit quality declines. However, the
difference between the default probabilities increases as cred-
it quality declines. The size of the difference between the two
default probability estimates is sometimes referred to as the
‘credit spread puzzle’.
The benchmark risk-free rate
The default probabilities implied from a bond price depend on
the bond’s yield spread over the risk-free rate. The estimates
in Figure 1 therefore depend critically on the assumption made
about the risk-free rate. A natural choice for the risk-free rate
is the Treasury rate. Treasury rates are yields on bonds that
have no default risk. Furthermore the bond yield spreads that
are quoted in the market are usually spreads relative to a
Treasury bond that has a similar maturity. However, Treasury
rates tend to be lower than other rates that have a very low
credit risk for a number of reasons:
■ Treasury bills and Treasury bonds must be purchased by
financial institutions to fulfill a variety of regulatory
requirements. This increases demand for these Treasury
instruments driving the price up and the yield down.
■ The amount of capital a bank is required to hold to sup-
port an investment in Treasury bills and bonds is substan-
tially smaller than that required to support a similar
investment in other very low-risk instruments.
■ In the United States, Treasury instruments are given a
favorable tax treatment compared with most other fixed-
income investments because they are not taxed at the
state level.
2 A similar point is made forcefully by Duffee, G. R., 1996 “Idiosyncratic variation of
132 treasury bill yields,” Journal of Finance, 51, 527-551. He argues that ‘Since the
early 1980’s [Treasury] bill yields have become increasingly irrelevant as a bench-
mark. This is not news to market participants…but nonetheless [is] likely a surprise
to many academic economists.’
This leads many market participants to regard swap rates as
better proxies for risk-free rates than Treasury rates.2
The credit default swap (CDS) market provides a way of esti-
mating the benchmark risk-free rate used by participants in
credit markets. If a five-year par yield corporate bond pro-
vides a yield of 6% and five-year protection can be bought
against the issuer for 150 basis points a year, an investor can
obtain a (approximate) risk-free return of 4.5% by buying the
bond and buying credit protection. This suggests that the
risk-free rate being used by market participants is 4.5%.
Using this type of analysis across many corporations we esti-
mate that the benchmark risk-free rate being used by market
participants is the swap rate less 10 basis points.3 This is sim-
ilar to estimates that have been made by Moody’s KMV.4 We
therefore set the risk-free rate equal to the seven-year swap
rate minus 10 basis points in producing the results in Figure 1.
It is worth noting that if we instead chose the risk-free rate to
be to be the seven-year Treasury rate the default probabili-
ties implied from bond prices would be even higher, making
the differences in Figure 1 even more marked. For example the
ratio of the risk-neutral to real world default probability for
A-rated companies in Figure 1 would rise from 9.8 to over 15.
Risk premiums
From the results in Figure 1 we can calculate the risk premi-
ums earned by holders of corporate bonds. The expected
excess return of corporate bonds over Treasuries has a num-
ber of components. One component is the difference between
the Treasury yield and our estimate of the benchmark risk-
free yield used by market participants. During the 92 months
covered by our Merrill Lynch data this averaged 43 basis
points. Another component is a spread to compensate for
defaults. Given that we are assuming a recovery rate of 40%,
this is the historic default probability in Figure 1 multiplied by
0.6. The final component is the extra risk premium earned by
the holders of corporate bonds. Note that if the risk premium
were zero, there would be no difference between historic
default probabilities and those derived from bond prices.
3 See J. Hull, M. Predescu, and A. White, 2004 “The relationship between credit
default swap spreads, bond yields, and credit rating announcements,” Journal of
Banking and Finance, Nov
4 For example, Stephen Kealhofer’s estimate of the risk-free rate in his presentation
at the Moody’s/New York University conference on Recent Advances in Credit Risk
Research in May 2004 was very close to our estimate.
JOURNAL13v06 16-02-2005 11:17 Pagina 133

bonds earn the risk premiums over the risk-free rate shown in
Rating Bond yield Spread of Spread to Extra risk
spread over risk-free rate compensate premium
Figure 2? There appear to be four main reasons:
treasuries used by market for historic
over treasuries default rate
■ Corporate bonds are relatively illiquid. It is less easy to sell
(% per annum) (% per annum) (% per annum) (% per annum)
corporate bonds than many other types of securities. As a
Aaa 0.83 0.43 0.02 0.38
Aa 0.90 0.43 0.04 0.43 result investors in corporate bonds demand what is
A 1.20 0.43 0.08 0.69 termed a liquidity risk premium. This is part of the risk
Baa 1.86 0.43 0.28 1.15
Ba 3.47 0.43 1.44 1.60
premium shown in the final column of Figure 2. Most
B 5.85 0.43 4.49 0.93 researchers estimate the liquidity risk premium to be
Caa and lower 13.21 0.43 10.14 2.64
between 10 and 25 basis points.
Figure 2: Excess expected returns earned by bond traders ■ Figures 1 and 2 assume that traders use historical data to
determine the probability of default in the future. In prac-
tice traders may be assigning positive subjective probabili-
Figure 2 shows the allocation of the yield spread into its vari- ties to depression scenarios that are much worse than any
ous components. For example, A-rated bonds earned 120 basis seen since 1970. If we use average default statistics for the
points more than Treasuries on average. Forty-three basis whole 1920 to 2003 period we find that the historic
points of this is the difference between Treasuries and the default probabilities in Figure 1 do increase somewhat. For
market’s risk-free benchmark. A further 8 basis points is nec- Aaa the historic default probability increases from 0.04%
essary to cover defaults. The remaining 69 basis points is a to 0.06%; for Aa it increases from 0.06% to 0.22%; for A
risk premium earned by bondholders. We can see from Figure it increases from 0.13% to 0.29%; for Baa it increases
2 that as the quality of the bond declines from Aaa to Ba the from 0.46% to 0.73%; and so on.
risk premium increases. It then declines as we move from Ba ■ Bonds do not default independently of each other. There
to B and increases sharply as we move from Ba to Caa. The are periods of time when default rates are very low and
extra risk premium reported in the last column of Figure 2 can other periods when they are very high. (Evidence for this
be characterized as the expected return on a portfolio that is can be obtained by looking at the default rates in different
long a corporate bond and short a default-free bond. years. Between 1970 and 2003 the default rate per year
ranged from a low 0.09% in 1979 to a high of 3.81% in
Our results are consistent with those produced by Edward 2001.) This phenomenon is sometimes referred to as ‘cred-
Altman some time ago. He showed that, even after taking it contagion’. It is a form of systematic risk (i.e., it is a form
account of the impact of defaults, an investor could expect of risk that cannot be diversified away) and bond traders
significantly higher returns from investing in corporate bonds should require a return in excess of the risk-free rate for
than from investing in Treasury bonds. As the credit rating of bearing this risk.
the corporate bonds declined, the extent of the higher returns ■ Bond returns are highly negatively skewed with limited
increased. (Altman found that B bonds ran counter to the upside. As a result it is much more difficult to diversify
overall pattern, just as we do in Figure 2.) risks in a bond portfolio than in an equity portfolio.6 A very
large number of different bonds must be held. In practice,
Reasons for the difference many bond portfolios are far from fully diversified. As a
Why are the probabilities backed out of bond prices in Figure 1 result bond traders may require an extra return for bear-
so much higher than those estimated from historical data? ing unsystematic risk as well as for bearing the systematic
An equivalent question is: Why do investors in corporate risk mentioned above.

5 Altman, E. I., 1989 “Measuring Corporate Bond Mortality and Performance,”

Journal of Finance, 44, 902-22. 133
6 See J. D. Amato and E. M. Remolona, “The pricing of unexpected credit losses,”
Working paper, Bank for International Settlements, Basel Switzerland.
JOURNAL13v06 16-02-2005 11:17 Pagina 134

Conclusions
In comparing Figures 1 and 2 we see that there are huge dif-
ferences between default probability estimates estimated
from corporate bond prices and those estimated from histori-
cal data. These differences translate into relatively modest
(but non-negligible) premiums demanded by bond traders for
the risks they are bearing. We have identified four types of
risk. The first is liquidity risk; the second is the risk that default
losses may be much worse than anything seen in recent histo-
ry; the third is the systematic (non-diversifiable) risk;s and the
fourth is the risk which is diversifiable but in practice quite dif-
ficult to handle.

134 - The Journal of financial transformation