A Multifactor Model of Credit Spreads

Abstract

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.