Understanding Common Factors in Domestic and International Bond Spreads

Abstract

In this paper, I study the determinants of credit spread changes of individual U.S. dollar denominated bonds - domestic and foreign sovereign - using fundamentals specified by structural models. Credit spreads are important determinants of the cost of debt for all issuers and are fully determined by credit risk in structural models. I construct a new dataset of domestic corporate and sovereign U.S. dollar bonds, which I use to find that changes in spreads not explained by fundamentals have two large common components that are distinct for each type of debt I study. Using a vector autoregressive (VAR) model, I find that domestic spreads are related to the lagged first component of sovereign spreads. Consequently, even though there is no contemporaneous common component in bond spreads, there seems to be a common component when focusing on the dynamics of these spreads. Traditional macro liquidity variables are related to the common components found in domestic and sovereign spread changes. My findings suggest possible explanations for the common component documented by previous research in domestic debt spreads. My research shows that, after taking into account the dynamics of the common components in credit spreads across debt types, the cost of debt for firms and countries depends to some extent on shocks that affect all types of debt.