Credit contagion channel and its consequences via the standard portfolio credit risk model

Using actual default events for all listed firms of 30 economies over the period from the first quarter of 2000 to the second quarter of 2011 and the technique of particle filtering and smoothing with MCMC, we find strong evidence that defaults of small-high-yield firms infect large-high-yield firms which, in turns, generate a feedback contagious effect back onto small-high-yield firms. We demonstrate that this type of credit contagion has a significant impact on the infected group's defaults and tail estimates of portfolio loss. All high-yield groups have systematic risk factors that exhibit a strong AR(1) effect which is an evidence of within group defaults clustering. All investment grade firms are not affected by this channel of credit contagion. In general, the lower grade high-yield firms have a higher default threshold measured in terms of asset value. Small firms are more vulnerable to default than large firms and their defaults could serve as an early warning signal for the system-wide credit contagion.