We represent credit spreads across ratings as a function of common unobservable factors of the meanreverting normal (Vasicek) form. Using a state-space approach we estimate the factors, their process parameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of structural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also contribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a systematic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to macroeconomic variables. This suggests that liquidity risk is largely driven by the same factors as default risk.

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We use a state-space model to represent the time-variation of credit spread indices by rating as a function of latent factors of the Vasicek form. By application of the Kalman Filter we simultaneously estimate the factor realizations, their process parameters, and the exposure of each observed credit spread series to each factor. A three-factor model is found to capture most of the time-variation in credit spreads across ratings, for any given maturity. Most significantly, the extracted factor series are closely correlated with the long bond rate, the implied volatility index (VIX), and the S&P500 level, suggesting that the three variables can explain the systematic variation in credit spreads across the quality spectrum.

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