Modern models for credit risk management
Evidence shows that a spread level of merely 25 bp was never achieved between 1989 and 2003 for Baa rated US corporate bonds. One reason is that from an economic perspective the default probabilities and recovery rates that were assumed to calculate the required spreads were too optimistic for this period. Especially between 1997 and 2002 the fundamental environment for corporate bonds was unfavorable. New technologies, company takeovers and equity buyback programs were primarily financed by the issuance of corporate bonds, resulting in an increased level of leverage in the corporate sector. Investors consequently required higher risk premia to invest in corporate bonds. One way to obtain more adequate estimates of required spreads is to use default probabilities and recovery rates that are typical for the current stage of the business cycle. Modern models for credit risk management and the pricing of credit derivatives account for the current economic environment. In particular, they differentiate between periods of expansion and contraction, because historically default rates increased and recovery rates fell during economic downturns, thus leading to a higher risk for credit investors. Additionally, a worst-case-scenario can be constructed assuming a zero per cent recovery value. A fair spread of 0.46 percent will be computed for Baa rated corporate bonds with a maturity of 5 years which is again a lot lower than the actually observed spreads.