HUMPBACKS IN CREDIT SPREADS

Deepak Agrawal and Jeffrey R. Bohn

Models of credit valuation generally predict a hump-shaped spread term structure for low quality issuers. This is understood to be driven by the shape of the underlying conditional default probabilities curve. We show that (a) recovery assumptions and (b) deviation of a bond’s price from its par value can also drive different term structure shapes. Our analysis resolves conflicting empirical evidence on the shape of speculative grade spread curves and explains the related existing theoretical results. On examining a large set of speculative grade bonds and credit default swaps, we find evidence that par-spread term structures are likely to be downward sloping as credit quality deteriorates sufficiently.