Understanding Corporate Bond Spreads Using Credit Default Swaps

Although the results are based on a small sample • of Canadian fi rms, they are consistent with recent research on how liquidity risk is priced in corporate bond markets. Since the beginning of the credit crisis in mid2007, corporate spreads worldwide widened markedly. In Canada, the aggregate spread for investment-grade fi rms reached a maximum of 401 basis points (bps) in January and March of 2009, substantially more than the historical average of 92 bps; the spread on the equivalent index in the United States reached 656 bps in December 2008, also substantially more than its historical average of 153 bps (Chart 1). Owing to the problems in funding markets, corporations and fi nancial institutions began to replace “risky” assets with “safer” ones; this “fl ightto-quality” effect resulted in large price declines in equity and corporate bond markets and increases in prices in the government market.