Humpbacks in Credit Spreads∗

Models of credit valuation generally predict a hump-shaped spread term structure for low quality issuers. This is understood to be driven by the shape of the underlying conditional default probabilities curve. We show that (a) recovery assumptions and (b) deviation of bond’s price from par can also drive different term structure shapes. On examining a large set of speculative grade bonds and credit default swaps, we find evidence that parspread term structures are likely to be downward sloping as credit quality deteriorates sufficiently. Our analysis explains the various theoretical results and resolves conflicting empirical evidence on the shape of speculative grade spread curves. ∗This paper has benefited from numerous discussions with researchers working in the area of credit risk. We would like to thank Navneet Arora, Saiyid Islam, Gene Janevathanavitya, Stephen Kealhofer, Farshad Mashayekhi and Oldrich Vasicek for comments and discussions. Any errors are ours. The views expressed in this paper are the authors’ own and do not necessarily represent the views of Moody’s KMV. †Moody’s KMV, 1620 Montgomery Street, Suite 140, San Francisco, CA 94111. Tel : (415) 229-0751, E-mail : [email protected], [email protected].