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Fixed Income and Credit Risk

Paper Session

Friday, Jan. 4, 2019 2:30 PM - 4:30 PM

Hilton Atlanta, Grand Ballroom D
Hosted By: American Finance Association
  • Chair: Monika Piazzesi, Stanford University

Default Risk and the Pricing of U.S. Sovereign Bonds

Robert Dittmar
,
University of Michigan
Alex Hsu
,
Georgia Institute of Technology
Guillaume Roussellet
,
McGill University
Peter Simasek
,
Georgia Institute of Technology

Abstract

United States Treasury securities are viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can be inflated away by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. We examine the relative pricing of nominal and inflation-indexed debt in the presence of risk of default. We show empirically that the breakeven inflation rate between nominal Treasury securities and TIPS is statistically significantly related to the premium paid on U.S. credit default swaps, controlling for measures of liquidity and slow-moving capital. This evidence motivates us to model the prices of nominal and inflation-protected securities in the presence of default risk. Our model shows that breakeven inflation is related to perceptions of differing rates of recovery in the two markets. Results from estimating our model suggest that we can simultaneously capture variation in breakeven inflation rates and United States Treasury credit default swap spreads.

A New Normal for Interest Rates? Evidence from Inflation-Indexed Debt

Jens Christensen
,
Federal Reserve Bank of San Francisco
Glenn Rudebusch
,
Federal Reserve Bank of San Francisco

Abstract

Researchers have debated the extent of the decline in the steady-state short-term real interest rate---that is, in the so-called equilibrium or natural rate of interest. We examine this issue using a dynamic term structure finance model estimated directly on the prices of individual inflation-indexed bonds with adjustments for real term and liquidity risk premiums. Our methodology avoids two pitfalls of previous macroeconomic analyses: structural breaks at the zero lower bound and potential misspecification of output and inflation dynamics. We estimate that the equilibrium real rate has fallen about 2 percentage points and appears unlikely to rise quickly.

Low Inflation: High Default Risk and High Equity Valuations

Harjoat Bhamra
,
Imperial College London
Christian Dorion
,
HEC Montreal
Alexandre Jeanneret
,
HEC Montreal
Michael Weber
,
University of Chicago

Abstract

We develop an asset pricing model with endogenous corporate policies that explains how inflation jointly impacts real asset prices and corporate default risk. Our model accounts for two important sources of nominal rigidity present in the data. First, nominal coupons paid to long-term corporate debt are fixed in the short run, that is, leverage is sticky. Second, in the short run, earning growth is less sensitive to variations in expected inflation than the nominal risk-free rate, that is, firm profitability is sticky. These features combined result in higher real equity prices and credit spreads when inflation falls. An increase in inflation has the opposite effects, but with smaller magnitudes. The relation between equity prices and inflation is thus asymmetric. In the cross-section, the model predicts the negative impact of inflation on real equity values and credit risk is stronger for low leverage firms. We find empirical support for our theoretical predictions.

The Term Structure of Credit Spreads with Dynamic Debt Issuance and Incomplete Information

Luca Benzoni
,
Federal Reserve Bank of Chicago
Lorenzo Garlappi
,
University of British Columbia
Robert Goldstein
,
University of Minnesota

Abstract

We investigate credit spreads and capital structure dynamics in a model in which management has private information regarding firm value and is able to issue both equity and debt to service existing debt. Rather than choosing to default, managers of investment-grade~(IG) firms who receive bad private signals conceal this information by servicing existing debt via new debt issuance. As such, firms with IG-commensurate spreads have zero jump-to-default risk (and hence, command zero jump-to-default premium), at least until their debt capacity is fully utilized and spreads have increased to "fallen angel" status. These predictions match observation well.
Discussant(s)
Luis Viceira
,
Harvard Business School
Jing Cynthia Wu
,
University of Chicago
Hui Chen
,
Massachusetts Institute of Technology
Nina Boyarchenko
,
Federal Reserve Bank of New York
JEL Classifications
  • G1 - General Financial Markets