Keywords: Credit spreads, term structure, interest rates, macroeconomic factors, financial leverage, volatility, dynamic factor mode, Kalman filter.
This paper presents an internally consistent analysis of the economic determinants of the term structure of credit spreads across
different credit rating classes and industry sectors. Our analysis proceeds in two steps. First, we extract three economic factors
from 13 time series that capture three major dimensions of the economy: inflation pressure, real output growth, and financial market
volatility. In the second step, we build a no-arbitrage model that links the dynamics and market prices of these fundamental sources of
economic risks to the term structure of Treasury yields and corporate bond credit spreads. Via model estimation, we infer the market
pricing of these economic factors and their impacts on the whole term structure of Treasury yields and credit spreads.
Estimation shows that positive inflation shocks increase both Treasury yields and credit spreads across all maturities and credit rating classes.
Positive shocks on the real output growth also increase the Treasury yields, more so at short maturities than at long maturities.
The impacts on the credit spreads are positive for high credit rating classes, but become negative and increasingly so at lower creditrating
classes. The financial market volatility factor has small positive impacts on the Treasury yield curve, but the impacts are strongly
positive on the credit spreads, and increasingly so at longer maturities and lower credit rating classes.
Finally, when we divide each rating class into two industry sectors: financial and corporate, we find that with in each rating class, the credit spreads in the financial
sector are on average wider and more volatile than the spreads in the corporate sector. Estimation further shows that the term structure of
credit spreads in the financial sector is more responsive to shocks in the economic factors.
Full paper (474 KB PDF)
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Last update: December 19, 2005