Jens Hilscher†, Robert A. Jarrow‡, and Donald R. van Deventer§
January 3, 2022
Abstract
This paper shows that, for a sample of corporate bond prices, credit spreads and therefore discount rates of promised coupons and principal differ substantially. To better fit this stylized fact we propose and estimate a tractable, arbitrage-free valuation model for corporate bonds that includes a more realistic recovery rate process. Existing spread calculations assume that coupons and principal have the same seniority. Thus, these spread calculations are misspecified because they include recovery rates for coupons due after default. Misspecification errors resulting from such a coupon recovery assumption depend on recovery rates, coupons, maturity, and default probabilities and can be substantial in size. We provide two pieces of evidence in support of the no-coupon recovery model: (i) for a large sample of bond market transactions our model has lower pricing errors than one assuming recovery on all coupons, and (ii) the model’s outperformance magnitude is closely linked to model misspecification errors.
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∗Helpful comments from John Y. Campbell and seminar participants at the Bank of England, the Bank of Finland, the Board of Governors of the Federal Reserve, the European Bank for Reconstruction and Development, the International Monetary Fund, the World Bank, Brandeis University, the 2019 GEA meetings at the Frankfurt School of Finance and Management, and the University of Technology, Sydney are gratefully acknowledged. We thank Tengda Gong for providing excellent research assistance.
†University of California, Davis, California 95616. email: jhilscher@ucdavis.edu.
‡Samuel Curtis Johnson Graduate School of Management, Cornell University, Ithaca, N.Y. 14853 and Kamakura Corporation, Honolulu, Hawaii 96815. email: raj15@cornell.edu.
§Kamakura Corporation, Honolulu, Hawaii 96815. email: dvandeventer@kamakuraco.com.