Credit Risk and Disaster Risk

JEL codes: 
E32, E44, G12
Series number: 
Version Date: 
Jan 2011

return on a well-diversified portfolio of corporate bonds is close to zero. In contrast, the empirical finance literature documents large and time-varying risk premia in the corporate bond market (the "credit spread puzzle"). This paper introduces a parsimonious real business cycle model where firms issue defaultable debt and equity to finance investment. The mix between debt and equity is determined by a trade-off between tax savings and bankruptcy costs. By their very nature, corporate bonds, while safe in normal times, are highly exposed to the risk of economic depression. This motivates introducing a small, time-varying risk of large economic disaster. This simple feature generates large, volatile and countercyclical credit spreads as well as novel business cycle implications. An increase in disaster risk makes default more systematic, leading to higher risk premia, and higher expected discounted bankruptcy costs, hence worsening financial frictions. This leads to a reduction in investment, output, and leverage. Financial frictions amplify significantly the effects of disaster risk: the response of investment and output is about three times larger than in the frictionless model.

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