Market-Based Default Rate Forecasting

Abstract

Forecasting the speculative-grade default rate provides an informational edge in managing both corporate bond risk and loan default risk. Credit analysts have developed three types of models for this purpose: actuarial, econometric, and market-based. Fridson and Sterling introduce a market-based model derived from the distress ratio, which is defined as the percentage of issues within the high-yield bond index quoted at spreads greater than 1,000 basis points, or 10 percentage points, over the rate on U.S. Treasuries. The Default Rate Projector estimates the one-year-forward default rate using historical default rates on distressed and non-distressed issues. Comparison of the model’s forecasts with subsequent, actual default rates shows that the market’s assessment of default risk is generally accurate.

TOPICS: Analysis of individual factors/risk premia, factor-based models, risk management