Default correlation: rating, industry ripple effect, and business cycle

For a well-diversified bond portfolio, default risk over the investment horizon is known as the major risk and the risk is largely from correlated defaults. While plenty of theoretical work about default correlation has been developed, empirical studies on default correlation have not made much prog...

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Bibliographic Details
Published in:Applied economics 2019-06, Vol.51 (30), p.3256-3273
Main Authors: Qi, Howard, Shi, Jian, Xie, Yan Alice
Format: Article
Language:English
Subjects:
and recession
Bond portfolios
bond rating
Bond ratings
Business cycles
Default
Default correlation
Economic analysis
Economic theory
industries
Portfolio diversification
Ratings & rankings
Supply
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Summary:For a well-diversified bond portfolio, default risk over the investment horizon is known as the major risk and the risk is largely from correlated defaults. While plenty of theoretical work about default correlation has been developed, empirical studies on default correlation have not made much progress in the past two decades. In this paper, we fill this void in the literature by thoroughly investigating how default correlation changes across different bond ratings, over different time horizons, and across different industries over the sample period of 1970 to 2014. In particular, we examine how rating-based default correlations change before, during, and after recessions. More importantly, we reveal the 'industry ripple effect' that default correlations are low within upstream industries but become higher within downstream industries along the structure of the supply chain. Also, default correlations are relatively high between upstream industries and downstream industries.
ISSN:0003-6846
1466-4283
DOI:10.1080/00036846.2019.1566689