Credit spreads, bond index changes and bond diversification

This thesis consists of four essays. In the first essay, we reexamine how default, taxes and systematic risk measures influence corporate credit spreads for investment grade corporate bonds for the 1987-1996 time period using a modified version of the methodology used in Elton, Gruber, Agrawal, and Mann (2001). The methodological improvements not only change the estimates for the default and tax components of credit spreads materially but the factors from the Fama and French three-factor model no longer help to explain the remaining variation in credit spreads. In contrast, a good portion of the variation in the remaining (unexplained) spread is explained by measures of aggregate bond liquidity. In the second essay, unlike the literature that deals extensively with the diversification of stock portfolios, we investigate diversification benefits for bond portfolios and the optimal portfolio size to achieve a low marginal benefit from increased portfolio size. Since the classic paper on bond diversification by McEnally and Boardman (1979), the structure of the bond market has changed significantly and many risk metrics have been introduced into the literature. In this essay, we use various risk metrics to assess the diversification benefits and the optimal bond portfolio sizes based on investment opportunity sets differentiated by credit ratings, issuer type and term to maturity. Our results suggest that a portfolio size of 25 to 40 bonds could be optimal since going beyond this size achieves a marginal diversification benefit of less than 1%.; In the third essay, we formulate and test an alternate model for explaining the changes in corporate credit spreads. The model includes some new potential determinants (such as undiversifiable risk) and uses ex ante (forecast) data from Consensus Economics instead of realizations for other determinants previously identified in the literature. Compared to other models previously tested in the literature, our model achieves substantially higher explanatory power while being more parsimonious.; Finally, in the fourth essay, we introduce what appears to be the first investigation of the impact of bond index additions and deletions on the returns of bonds and stocks of the same-firm issuers using various unconditional and conditional return-generating models. The effect of additions and deletions is symmetric for each asset class and robust across various return-generating models. While bond returns are positively (negatively) affected by bond index inclusions (exclusions), stock returns are unaffected by these bond index revisions. These results suggest that, although bond index additions and deletions materially affect bond values when measured at market, equity investors do not perceive any material change in financial risk from such changes.