David Lando and Allan Mortensen
Volume 3, Number 4, Fourth Quarter 2005
The term structure of interest rates contains information about the market’s expectations of the direction of future interest rates. Similarly, the term structure of credit spreads contains information about the market’s perception of future credit spreads. The term structure of credit spreads is closely linked with conditional default probabilities and this link suggests a downward sloping term structure of credit spreads for high risk issuers, whose default probability conditional on survival is likely to decrease. This paper shows that for sufficiently low credit quality, as defined by the level of credit spreads, this holds true most of the time when spreads are taken from credit default swap (CDS) markets. We also discuss why CDS markets give a better way of analyzing this problem than bond price data.