What drives corporate default risk premia? Evidence from the CDS market

• We study the factors behind corporate default risk premia in Europe during 2006–2010.
• We employ Credit Default Swap (CDS) prices to obtain estimates of default swap premia.
• Default risk premium is decomposed into distress and jump-at-default risk premia.
• Results show a strong commonality behind distress and jump-at-default risk premia.
• Aggregate illiquidity and sovereign risk are pricing factors of default risk premia.

This article studies the economic factors behind corporate default risk premia in Europe during the period 2006–2010. We employ information embedded in Credit Default Swap (CDS) contracts to quantify expected excess returns from the underlying bonds in market-wide default circumstances. We disentangle the compensation to investors for unexpected changes in the creditworthiness of the bond issuer from their remuneration for the risk that the bond's price will drop in the event of default. Our results show that the risk premia associated with systematic factors influencing default arrivals represent approximately 40% of total CDS spread (on median). These premia also exhibit a strong source of commonality; a single principal component explains approximately 88% of their joint variability. This factor significantly covaries with aggregate illiquidity and sovereign risk variables. Empirical evidence suggests a public-to-private risk transfer between sovereign credit spread and corporate risk premia. Finally, the compensation in the event of default is approximately 14 basis points of the total CDS spread, and a significant amount of jump-at-default risk may not be diversifiable.