Derivatives

Cash-Flow Maturity and Risk Premia in CDS Markets

Topics - Derivatives

${ numberSection } ${ text }
Cash-Flow Maturity and Risk Premia in CDS Markets

Working paper

One of the main determinants of the riskiness of a corporate bond is its maturity. Long-maturity obligations tend to be more sensitive to changes in credit fundamentals and in interest rates than short-maturity bonds. While it has been documented that the higher sensitivity to shifts in interest rates does not translate in proportionally higher expected returns, less is known about the impact of higher sensitivities to credit fundamentals. The author aims to fill this gap by studying the risk adjusted returns of credit default swaps of different maturities.

Credit default swaps (CDS) are derivative contracts that work like insurance on bonds issued by a corporation or sovereign. They have the same sensitivity to default as a corporate bond of similar maturity, but no interest exposure, i.e. they provide a pure credit exposure. Furthermore, while a typical corporation has only a few bond issues outstanding at a time that may differ in terms besides maturity, CDS contracts are homogenous and are available in a grid of standard maturities. Leveraging these two unique features of CDS markets, the author shows that the risk premium earned by assets exposed to long-term credit risk is not sufficiently higher to compensate for their heightened volatility and, as a consequence, short-maturity credit default swaps have higher risk-adjusted returns. The finding is robust: it holds among high-yield and investment grade single-name credit default swaps as well as the more liquid multi-name CDS indexes in Europe and United States.

The author then sheds light on the properties that distinguish short- and long-term CDSs. While on average they have similar correlations to the aggregate credit market, their dynamic is very different. Short-term CDSs have relatively lower correlations to credit markets in calm times, but in stress times like the financial crisis and the early 2000’s, they become more correlated. This increase in riskiness at times that investors are more likely to demand higher risk premiums can quantitatively explain the higher risk-adjusted returns of short-term CDSs.

Lastly, the author works out the implications of his findings to economic models used to explain asset prices. He shows that a model in which investors are concerned with short-lived spikes in uncertainty can quantitatively rationalize the higher risk-adjust returns of short-maturity credit default swaps.

AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.