Decomposition of country-specific corporate bond spreads

This paper presents a new approach, based on the Merton model, to decomposing corporate bond spreads into the expected loss, bond risk premium and liquidity premium components. The approach focuses on establishing the bond risk premium using the equity risk premium and the hedge ratio, which are estimated using a dividend discount model and a BEKK-GARCH model. The analysis focuses on non-financial European BBB-rated corporate bonds and distinguishes explicitly between German, French, Spanish and Italian firms. The results show that the bond risk premium is the largest component. While the expected loss component made the greatest contribution to the strong widening of the spreads around the turn of 2008/09, the spreads were then heavily dominated by the bond risk premium and investors received relatively low or, at times, no compensation for expected losses. The safe interest rate and the sovereign CDS premiums are key determinants of the expected loss component and the bond risk premium.