“How Does Low for Long Impact Credit Risk Premia?” by Professor Antje Berndt
Australian National University
The Federal Reserve's experiments in monetary policy related to the Global Financial Crisis lasted longer than any previous easing cycle, giving rise to the question of how does a long-term, low-interest-rate environment affect the pricing of credit risk. We decompose credit default swap (CDS) rates into expected losses and credit risk premia, and show that the level of and firms' exposure to systematic default risk, controls for mis-measuring expected losses and proxies for CDS market liquidity explain more than 80% of the variation in risk premia across firms and over time. We show that in the zero lower bound period, residual risk premia are lower for high-yield debt compared to investment-grade debt — consistent with a reaching for yield interpretation. Our fndings are also consistent with investors demanding compensation for ambiguity aversion related to the end of the low-rate environment, a decrease in the supply of risk capital and higher costs of trading credit risky instruments due to regulatory changes.