Treasury yields and credit spread dynamics: A regime-switching approach

Abstract

The purpose of this paper is to shed new light on the conflicting empirical evidence on the relationship between credit spreads and Treasury rates. Following a general-to-specific modeling approach, we were unable to accept the presence of a long-run relationship between Baa credit spreads and long-term Treasury rates. At the same time, and in support of the structural models on credit risk modeling, a negative short-run relationship was obtained by means of impulse response functions. Subsequently, by employing a regime-switching estimation technique, we were able to establish the importance of the Treasury yield curve slope for the Baa credit spread determination in periods characterized by low interest rate volatility. Finally, we were able to provide evidence of an asymmetric response of the Baa credit spread to term spread changes according to the source of these changes, i.e. short or long term Treasury rates.