Anchoring Credit Default Swap Spreads to Firm Fundamentals

Abstract

In this article, we examine the extent to which firm fundamentals can explain the cross-sectional variation in credit default swap (CDS) spreads. We construct a fundamental CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamentals via a Bayesian shrinkage method. Regressing CDS quotes against the fundamental valuation cross-sectionally generates an averageR2of 77%. The explanatory power is stable over time and robust in out-of-sample tests. Deviations between market quotes and the valuation predict future market movements. The results highlight the important role played by firm fundamentals in differentiating the credit spreads of different firms.