A Credit Spread Decomposition: A Resolution of the Credit Spread Puzzle

The empirical evidence showing that a corporate bond’s expected loss is only a small portion of a bond’s credit spread is called the credit spread puzzle. This paper, using a reduced-form credit risk model, characterizes a risky bond’s credit spread. This characterization provides a more general measure of a risky bond’s credit risk and it shows that, in an arbitrage-free market, a bond’s credit risk is only a fraction of the credit spread and not linearly related to the one-year, risk-neutral expected loss, resolving the credit spread puzzle.