Default Risk Premia and Asset Returns

We identify a common default risk premia (DRP) factor in the risk-adjusted excess returns on pure default-contingent claims. Asset pricing tests using almost 50 corporate bond portfolios sorted on rating, maturity or industry suggest that the DRP factor is priced in the corporate bond market. For index put option portfolios sorted on maturity and moneyness, both average returns and DRP beta estimates become more negative with decreasing time to maturity. There is little to no evidence of the DRP factor being priced in equity markets. Most of the variation in DRP is explained by the portion DRP^{JtD} due to common jump-to-default risk premia. A theoretical framework where DRP^{JtD} is part of the pricing kernel supports our empirical findings.

Bank borrowing and corporate risk management

We examine whether banks better protect themselves against risk-shifting as compared to non-bank lenders by comparing risk management polices across firms that borrow from different lenders using a unique, hand-collected data set of hedging and borrowing practices. Consistent with banks being effective monitors, we find hedging is positively associated with the proportion of bank debt amongst firms with large risk-shifting incentives. We present descriptive evidence showing that banks use covenants as one of the channels to mitigate risk-shifting.Hedging Risk-shifting Bank debt Covenants Risk management

Why ratings matter: Evidence from Lehman’s index rating rule change. Working Paper

Abstract We examine institutional price pressure in corporate bond markets by exploiting an unanticipated mechanical change in how a Lehman's bond index is constructed. We show that bond market segmentation into investment-grade and high-yield sectors because of rating-based regulation has a first-order impact on security prices. Institutional investors with investment constraints increase their holdings of split-rated bonds that are now mechanically considered investment-grade instead of high-yield by Lehman, resulting in temporary order imbalances that creates positive price pressure. Bonds that are mechanically upgraded to investment-grade exhibit large capital flows and experience positive abnormal returns of +200 basis points over a two week horizon. Price reactions are transitory, however, and vanish after twenty to thirty days. Similarly, bonds that were expected to downgrade to high-yield but were mechanically upgraded also exhibit transitory positive abnormal returns and reduced net selling. Taken together, our results suggest that the demand curve for bonds is downward-sloping in the short run. JEL Classification: G12, G1

Why Ratings Matter: Evidence from Lehman's Index Rating Rule Change

This paper examines the role of bond ratings and the effects of rating-based regulations in the corporate bond market. Exploiting an unanticipated mechanical change in how the benchmark Lehman bond indices are constructed in 2005, we show that rating-induced market segmentation of the bond market into investment-grade and high-yield sectors has a first-order impact on bond prices. Bonds that are mechanically upgraded to investment-grade due to the Lehman announcement have positive abnormal returns of two percent on average and exhibit abnormal order flows over several months. The abnormal bond returns are larger for bonds with longer maturities and higher turnover. We find that institutional investors with rating's-based portfolo constraints substantially increase their holdings in the aected bonds. In addition, return correlations with the investment-grade index increase for the upgraded bonds. Bonds on watch for downgrade to high-yield but with favorable Fitch rating experience reduced selling and rapid price recovery.Corporate bond market, rating agencies, rating-based regulation, market segmentation, liquidity, index addition, institutional investors