Global Integration of Developed Credit Markets

Abstract

Return correlations in the U.S. dollar and euro credit markets are systematically different on at least two dimensions: returns for normal day–to–day spread changes versus spread returns associated with extreme events; and spread returns for investment–grade versus speculative issuers. A large part of the return correlation is driven by extreme global events such as the 2001 terrorist attacks or the 2002 credit crisis ensuing on the Enron meltdown. Under more normal market conditions, euro and U.S. dollar credit markets are weakly linked, especially for highly rated debt. Returns on speculative debt issued by the same issuer in different markets tend to be highly correlated; this is less so for high–grade issuers. An immediate implication is that currency diversification is much more efficient than name diversification for high–grade debt. Conversely, high–yield portfolios benefit from name or even sector diversification more than they benefit from currency diversification. Risk models need to include currency–dependent factors, particularly for investment–grade instruments. The results provide some indication of the way to use global credit factors or factor return proxies to estimate credit risk in markets lacking much corporate bond data.