Default Spreads and Bond Maturity

From observation, the default spread for corporate bonds of a given ratings class seems to increase with the maturity of the bond. In Figure 7.2, we present the default spreads estimated for an AAA, BBB and CCC rated bond for maturities ranging from 1 to

Figure 7.2: Default Spreads by Maturity

Figure 7.2: Default Spreads by Maturity

1 yr

2 yr

Maturity

7 yr

10 yr

1 yr

2 yr

Maturity

7 yr

10 yr

10 years in January 2001.

For every rating, the default spread seems to widen for the longer maturities and it widens more for the lower rated bonds. Why might this be? It is entirely possible that default risk is multiplied as we look at longer maturities. A bond investor buying a 10-year bond in a

CCC rated company may feel more exposed to default risk than a bondholder buying a higher rated bond.

Default Spreads over Time

The default spreads presented in Table 7.6, after a year of declining markets and a slowing economy, were significantly higher than the default spreads a year prior. This phenomenon is not new. Historically, default spreads for every ratings class have increased during recessions and decreased during economic booms. In Figure 7.3, we graph the spread between 10-year Moody's Baa rated bonds and the 10-year treasury bond rate each year from 1960 to 2000.

Figure 7.3: Default Spread - Baa versus Treasury Bond Rates from 1960 to 2000

Figure 7.3: Default Spread - Baa versus Treasury Bond Rates from 1960 to 2000

Year

—■— Baa Rate Treasury Bond rate -X- Baa - T.Bond Rate

Year

—■— Baa Rate Treasury Bond rate -X- Baa - T.Bond Rate

The default spreads did increase during periods of low economic growth; note the increase during 1973-74 and 1979-81, in particular. In fact, a regression of default spreads each year against real economic growth that year bears out this conclusion.

Default SpreadBBB-Treasuy = 0.47 - 0.04 GNP Growth^ After years of high real growth, default spreads tend to shrink.

The practical implication of this phenomenon is that default spreads for bonds have to be re-estimated at regular intervals, especially if the economy shifts from low to high growth or vice versa.

rcitings.xls: There is a dataset on the web that summarizes default spreads by bond rating class for the most recent period.

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