Credit Spread Changes Research Articles

An Empirical Study of US Corporate Credit Spreads

This paper presents an analysis of the factors that affect US corporate credit spreads. Using data from Bloomberg we investigate the various determinants that cause changes in credit spreads of US corporate firms. As previous research has shown, the variables that should be based on theory determine credit spread changes have limited explanatory power. Our study breaks apart a range of variables into three different sections and analyzes them individual in the groups and together using multiple regressions. We investigate the spot rate, interest rate volatility and slope for the interest rate effects and find strong relationships between spot rate and slope with credit spreads. For the effects of volatility and market uncertainty we find strong relationships between credit spreads and market volatility proxied by VIX and firm volatility proxied by an average of Call and Put implied volatility. TED spreads, SPX and RTY returns show strong relationships between macro-economic variables and credit spreads. Implied default correlations in the Investment Grade and High Yield market also show a strong positive relationship with credit spreads. Our research investigates certain macro-economic variables that have not been researched before and re-establishes previous findings for other variables post-2007 crisis.

Tiebreaker: Certification and Multiple Credit Ratings

ABSTRACTThis paper explores the economic role credit rating agencies play in the corporate bond market. We consider three existing theories about multiple ratings: information production, rating shopping, and regulatory certification. Using differences in rating composition, default prediction, and credit spread changes, our evidence only supports regulatory certification. Marginal, additional credit ratings are more likely to occur because of, and seem to matter primarily for, regulatory purposes. They do not seem to provide significant additional information related to credit quality.

EURO CORPORATE BOND RISK FACTORS

SUMMARYThis paper investigates the determinants of credit spread changes in euro‐denominated bonds. We adopt a factor model framework, inspired by the credit risk structural approach, as credit spread changes can be easily viewed as an excess return on corporate bonds over Treasury bonds. We try to assess the relative importance of market and idiosyncratic factors as an explanation of movements in credit spreads. We adopt a heterogeneous panel with a multifactor error model and propose a two‐step estimation procedure, which yields consistent estimates of unobserved factors. The analysis is carried out with a panel of monthly redemption yields on a set of corporate bonds for a time span of 3 years. Our results suggest that the euro corporate market is driven by observable and unobservable factors. The unobservable factors are identified through a consistent estimation of individual and common observable effects. The empirical results suggest that an unobserved common factor has a significant role in explaining the systematic changes in credit spreads. However, in contrast to evidence regarding US credit spread changes, it cannot be identified as a market factor. Copyright © 2011 John Wiley & Sons, Ltd.

The determinants of sovereign credit spread changes in the Euro-zone

Using a database of Euro-denominated government bonds covering the period from January 2000 to December 2010, this paper provides an empirical analysis of the determinants of government credit spreads in the Euro-area. The analysis is divided into two sub-periods delimited by the global financial crisis that started in August 2007. We find evidence of a clear shift in the behavior of market participants from a convergence-trade expectation, based on market related factors, before August 2007, to one mainly driven by macroeconomic country-specific variables and an international common risk factor. There is no evidence of a significant role for the liquidity risk before or during the financial crisis period. Overall, our results give support to the Merton-type structural credit risk models and confirm that there are considerable similarities between the factors explaining the dynamics of the credit risk spreads and the factors driving the prices on the government bond markets.

Credit Spread Changes and Equity Volatility: Evidence from Daily Data

We investigate the determinants of daily changes in credit spreads in the U.S. corporate bond market. Using a sample of liquid investment grade and high-yield bonds, we show that both systematic bond and stock market factors as well as idiosyncratic equity market factors affect changes in the yield spread at the daily frequency. In particular, we find that increase in stock market volatility has a positive effect on changes in the spread of corporate bonds over the corresponding Treasuries beyond that captured by standard term structure variables. Our

Securitized banking and the run on repo

The panic of 2007–2008 was a run on the sale and repurchase market (the repo market), which is a very large, short-term market that provides financing for a wide range of securitization activities and financial institutions. Repo transactions are collateralized, frequently with securitized bonds. We refer to the combination of securitization plus repo finance as “securitized banking” and argue that these activities were at the nexus of the crisis. We use a novel data set that includes credit spreads for hundreds of securitized bonds to trace the path of the crisis from subprime-housing related assets into markets that had no connection to housing. We find that changes in the LIB-OIS spread, a proxy for counterparty risk, were strongly correlated with changes in credit spreads and repo rates for securitized bonds. These changes implied higher uncertainty about bank solvency and lower values for repo collateral. Concerns about the liquidity of markets for the bonds used as collateral led to increases in repo haircuts, that is the amount of collateral required for any given transaction. With declining asset values and increasing haircuts, the US banking system was effectively insolvent for the first time since the Great Depression.

Price Discovery of Credit Spreads in Tranquil and Crisis Periods

In this paper we investigate the price discovery process in single-name credit spreads obtained from bond, credit default swap (CDS), equity and equity option prices. We analyse short term price discovery by modelling daily changes in credit spreads in the four markets with a vector autoregressive model (VAR). We also look at price discovery in the long run with a vector error correction model (VECM). We find that in the short term the option market clearly leads the other markets in the sub-prime crisis (2007-2009). During the less severe sovereign debt crisis (2009-2012) and the pre-crisis period, options are still important but CDSs become more prominent. In the long run, deviations from the equilibrium relationship with the option market still lead to adjustments in the credit spreads observed or implied from other markets. However, options no longer dominate price discovery in any of the periods considered. Our findings have implications for traders, credit risk managers and financial regulators.

How Costly is Sovereign Default? Evidence from Financial Markets

We use stock market data to test cross-sectional implications of theories of sovereign default and provide a market-based estimate of sovereign default costs. We find that the stock prices of firms vulnerable to financial intermediation disruption, or firms more exposed to the government, are particularly sensitive to changes in sovereign credit spreads. This is consistent with theories in which default is costly because it disrupts financial intermediation and damages government reputation. Estimation of a structural valuation model indicates that the market prices stocks as if sovereign default has large effects on vulnerable stocks, translating to a 12% destruction of the value of their productive assets.

Can broker–dealer client surveys provide signals for debt investing?

We use a novel data set to study return predictability in debt markets. The data are collected from J.P. Morgan’s periodic surveys on its clients’ outlook for changes in US Treasury yields and corporate credit spreads. We document that simple signals constructed from such surveys predict excess returns on debt portfolios formed on the basis of duration (2-years minus zero) or credit quality (BBB minus AAA). A linear trading strategy placing equal weight on Treasury and Credit signals has an annualized Information Ratio equal to 1.18, before transaction costs. We also show that predictability is likely to stem from private information possessed by survey respondents rather than from risk premia.

Vulnerability of Risk Management Systems in Credit Spread Widening Scenarios

During 2008, the sudden widening of credit spreads led to a rapid decrease in the value of many financial assets, revealing a general shortage of capital for many financial institutions, with some critical peaks that required fund injection and public bailouts. The evidence of a substantial underestimation of the risk related to a general credit spread widening leads to investigate the reason why risk management systems, in the early stage of the financial crisis, were not able to capture the accumulation of such a high potential of losses. Primarily, it is questioned whether the most unexpected event was the magnitude of the spread widening or, rather, the extent of the price reaction to that factor. The present work is mainly focused on the second front. In particular, it explores the possibility of including in the pricing techniques of financial instruments, a treatment of expected losses that is aligned with the most common methodologies for credit risk evaluation. The refinement of the cash flow mapping techniques leads to detect how, in the phases of severe credit spread widening, modified duration could result in an inaccurate measure of interest rate risk, but primarily it does not recognise the spread risk in the floater component of a portfolio. A slight revision of the evaluation models allows to identify two specific sensitivity measures, to interest rate and credit spread changes, both functional to the improvement of risk management systems, in order to make them highly sensitive to the spread risk effect.

Market Regimes, Sectorial Investments, and Time-Varying Risk Premiums

As an extension to the Fama and French three factor model (FF), this paper investigates the time-varying risk premiums of sector exchange traded funds (ETF) under a Markov regime-switching framework. In addition to the three style factors in the FF model, three macro factors: changes in market volatility, yield spread, and credit spread, are included in the proposed model. Using a maximum likelihood method, we categorize the economic market into three regimes: Bull, Bear, and Transition. We find all regimes are persistent with the bull market being the most persistent and the bear market being the least persistent over time.Risk premiums of the sector ETFs are highly regime dependent and the sensitivity of the funds to the risk factors are also regime dependent with positive or negative relations depending on the regimes. In contrast with the FF model, the proposed model yields substantial improvement in explaining the variation of the funds' returns using the selected six factors. Under the regime-switching framework, the sensitivities of the funds to the style and macro factors are shown to be more significant than the model without regime-switching.

Determinants of credit spread changes for the financial sector

PurposeMost of the credit spread literature deals with the determinants of credit spread changes for individual bonds. The purpose of this paper is to investigate the explanatory power of credit spread changes and their determinants for portfolios.Design/methodology/approachUsing ordinary least squares (OLS) regressions and monthly data from 1990 to 1997, this paper tests several new potential determinants (e.g. portfolio diversification) and expectations (and realizations) for some previously identified determinants (e.g. gross domestic product (GDP)) of credit spread changes for portfolios of financials as derived from spot curves.FindingsStrong empirical support is reported that default risk and undiversified risk are priced in credit spreads. The paper finds that forecasts for GDP and inflation are better determinants of credit spread changes than the realized values previously used in the literature, which is consistent with the notion that term structures convey expectations about future interest rates.Research limitations/implicationsInteresting issues for future research include the sensitivity of the results to the use of other procedures for deriving zero‐coupon spot rates, and whether forecasts of macrovariables (such as GDP) are better determinants of credit spreads for other industrial categories, such as utilities and industrials.Practical implicationsThe findings provide guidance for the management of risk for fixed income portfolios, for the pricing of fixed income securities differentiated by the difficulties encountered in achieving well‐diversified portfolios, and for assessing the performance of credit spread portfolios managed by financial institutions.Originality/valueThe empirical model, which achieves substantial explanatory power while being parsimonious, is the first to support the usage of forecasts instead of realized values in determining credit spreads, and to show that undiversifiable risk is an important component of the credit spreads of portfolios.

Corporate bond credit spreads and forecast dispersion

Recent research establishes a negative relation between stock returns and dispersion of analysts’ earnings forecasts, arguing that asset prices more reflect the views of optimistic investors because of short-sale constraints in equity markets. In this article, we examine whether a similar effect prevails in corporate bond markets. After controlling for common bond-level, firm-level, and macroeconomic variables, we find evidence that bonds of firms with higher dispersion demand significantly higher credit spreads than otherwise similar bonds and that changes in dispersion reliably predict changes in credit spreads. This evidence suggests a limited role of short-sale constraints in our corporate bond data sets. Consistent with a rational explanation, dispersion appears to proxy largely for future cash flow uncertainty in corporate bond markets.

Credit Spread Changes within Switching Regimes

Empirical studies on credit spread determinants are predicated on the presence of a single-regime over the entire sample period and thus find limited explanatory power. We show that a single regime model hides the fact that the explanatory variables take on different loadings across changing patterns in credit spreads. We capture these hidden effects by modeling endogenous (rating-specific) regimes for credit spreads. We find that in a two regime-based model traditional determinants have significant explanatory power consistent with the prediction of structural models, yet their importance changes across regimes -- some variables have their effects strengthen, weaken or even reverse signs across regimes. We also investigate the differing behavior of these loadings across different specifications of the economic cycle and find that endogenous regimes best capture the hidden effects of these variables with the highest explanatory power for the same set of variables.

Credit Frictions and Optimal Monetary Policy

We extend the basic (representative-household) New Keynesian [NK] model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers, that can vary for either exogenous or endogenous reasons. We find that the mere existence of a positive average spread makes little quantitative difference for the predicted effects of particular policies. Variation in spreads over time is of greater significance, with consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation. Nonetheless, we find that the target criterion - a linear relation that should be maintained between the inflation rate and changes in the output gap - that characterizes optimal policy in the basic NK model continues to provide a good approximation to optimal policy, even in the presence of variations in credit spreads. We also consider a "spread-adjusted Taylor rule," in which the intercept of the Taylor rule is adjusted in proportion to changes in credit spreads. We show that while such an adjustment can improve upon an unadjusted Taylor rule, the optimal degree of adjustment is less than 100 percent; and even with the correct size of adjustment, such a rule of thumb remains inferior to the targeting rule.

Liquidity Commonality Across the Bond and CDS Markets

The article examines various liquidity measures across the corporate bond and credit default swap (CDS) markets. The results, from the factor decompositions for individual liquidity measures and across various measures, show a strong liquidity commonality across the bond and CDS markets. In addition, the article finds that the liquidity common factor has significant impact on the unexplained part of the credit spread changes by default risk factors.

Bond Market Turnover and Credit Spread Changes

Recent research on default risk has shown that most of the variation in credit spreads is driven by a common yet unidentifiable factor. I find that bond turnover explains up to 11% of this variation. Using the implications of an intertemporal capital asset pricing model, I construct a bond hedging portfolio from TRACE transactions data and relate its return to changes in credit spreads. In theory, this portfolio captures the dynamic risk of the economy and, hence, hedges the risk of changes in market conditions. My findings are as follows. First, credit spreads relate asymmetrically to the return on the bond hedging portfolio. When market conditions are risky, the return on the bond hedging portfolio is positive and credit spreads increase significantly. During unchanged or less risky market conditions, the return on the bond hedging portfolio is small or negative, and credit spreads are less sensitive. Second, on average, credit spreads do not relate to a similar hedging portfolio constructed from equity volume data. The return on the stock hedging portfolio, however, captures some variation in credit spreads for riskier bond classes. Third, in contrast to the results for equity markets, where stock returns and volume are weakly related, this paper finds a strong link between volume and credit spreads in corporate bond markets.

Credit Frictions and Optimal Monetary Policy

We extend the basic (representative-household) New Keynesian [NK] model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers, that can vary for either exogenous or endogenous reasons. We find that the mere existence of a positive average spread makes little quantitative difference for the predicted effects of particular policies. Variation in spreads over time is of greater significance, with consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation. Nonetheless, we find that the target criterion - a linear relation that should be maintained between the inflation rate and changes in the output gap - that characterizes optimal policy in the basic NK model continues to provide a good approximation to optimal policy, even in the presence of variations in credit spreads. We also consider a spread-adjusted Taylor in which the intercept of the Taylor rule is adjusted in proportion to changes in credit spreads. We show that while such an adjustment can improve upon an unadjusted Taylor rule, the optimal degree of adjustment is less than 100 percent; and even with the correct size of adjustment, such a rule of thumb remains inferior to the targeting rule.

Empirical Evaluation of Hybrid Defaultable Bond Pricing Models

A four‐factor model (the extended model of Schmid and Zagst) is presented for pricing credit risk related instruments such as defaultable bonds or credit derivatives. It is an advancement of an earlier three‐factor model. In addition to a firm‐specific credit risk factor, a new systematic risk factor in the form of GDP growth rate is included. This new model is set in the context of other hybrid defaultable bond pricing models and empirically compared to specific representatives. We find that a model based only on firm‐specific variables is unable to capture changes in credit spreads completely. However, it is shown that in this model, market variables such as GDP growth rates, non‐defaultable interest rates and firm‐specific variables together significantly influence credit spread levels and changes.

The credit spread dynamics of Latin American euro issues in international bond markets

This paper investigates two important relationships using the sovereign issues made by major Latin American economies in the international bond market: the determinants of credit spread changes using variables derived from structural and macroeconomic theory and the impact of a default episode on the underlying equilibrium dynamics. We find four significant determinants of credit spread changes: an asset and interest rate factor—consistent with structural models of credit spread pricing; the exchange rate—consistent with macroeconomic determinants and the slope of the yield curve—consistent with a business cycle effect. Also, an intra-regional analysis of sovereign yields reveals a shift in the long-run equilibrium dynamics around the Argentine default on the 23 December 2001.