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Stats › Valuation › Credit spread puzzle

Expected default losses explain almost none of an AAA spread and most of a B spread

Rating, 3 to 5 yearsSpreadExpected default lossResidual
AAA63.86bp0.18bp63.68bp
AA71.22bp1.44bp69.78bp
A102.91bp2.78bp100.13bp
BBB170.89bp20.12bp150.77bp
BB364.55bp126.74bp237.81bp
B691.81bp400.52bp291.29bp

Average option adjusted spreads and expected default losses in basis points, US corporate bond indices, January 1997 to August 2003. The residual column is the arithmetic difference, and the source states the AAA and B residuals directly as 64 and 291 basis points. These are sample averages, not regression estimates, and no significance tests are reported.

Expected default loss explains about one tenth of one percent of the AAA one to three year spread, about 12% of the BBB three to five year spread and about 58% of the B spread. The residual is compensation for something other than defaults.

About 0.1%Share of the AAA one to three year spread explained by expected default loss
About 12%The same for BBB at three to five years
About 58%The same for B at three to five years
64bpUnexplained residual on AAA at three to five years

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