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Finance and Economics Discussion Series

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Credit Risk and Financial Regulations Financial Markets and Investment Strategies Stochastic processes and financial applications

Abstract

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 credit rating 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 within 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. JEL Classification: E43; G12; G13.

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References

1973The Pricing of Options and Corporate Liabilities 1974ON THE PRICING OF CORPORATE DEBT: THE RISK STRUCTURE OF INTEREST RATES*1987Parsimonious Modeling of Yield Curves 1996A YIELD‐FACTOR MODEL OF INTEREST RATES 2001The Determinants of Credit Spread Changes 1995A Simple Approach to Valuing Risky Fixed and Floating Rate Debt 2004Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market 2005The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications*

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