A credit spread puzzle for reduced-form models

Reduced-form models of default calibrated to expected default losses and comovements between default losses and an equity-based pricing kernel generate CDS spreads that tend to fall below historical values. In frictionless markets, resolving this credit spread puzzle requires credit-market investors, especially those in high-quality debt, to be more risk adverse than equity-market investors. In the absence of market segmentation, however, the puzzle points to a liquidity component that, depending on themodel specification, can account for more than half of historical CDS spreads. These findings caution against fitting reduced-formmodels to CDS spreads without accounting formarket segmentation or frictions.