Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indices

Abstract

Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond IndexesWe examine the question of the determinants of corporate bond credit spreads using both weekly and monthly option-adjusted spreads for nine corporate bond indexes from Merrill Lynch from January 1997 to July 2002. We find that the Russell 2000 index historical return volatility and the Conference Board composite leading and coincident economic indicators have significant power in explaining credit spread changes, especially for high yield indexes. Furthermore, these three variables plus the interest rate level, the historical interest rate volatility, the yield curve slope, the Russell 2000 index return, and the Fama-French [1996] high-minus-low factor can explain more than 40% of credit spread changes for five bond indexes. In particular, these eight variables can explain 67.68% and 60.82% of credit spread changes for the B-and the BB-rated indexes, respectively. Our analysis confirms that credit spread changes for high-yield bonds are more closely related to equity market factors and also provides evidence in favor of incorporating macroeconomic factors into credit risk models.

A Multifactor Model of Credit Spreads

“…To the extent that equity volatility is a proxy for a firm's asset value volatility, this result is consistent with the prediction of Merton (1974) that the probability of default and credit spreads increase with higher asset value volatility. The sharpest increase occurs in the crossing from investment to sub-investment grade bonds, which is consistent with the observations of Huang and Kong (2003) and others that lower-grade bonds are more sensitive to equity market variables than high-grade bonds.…”

“…In general, low-grade bond spreads are observed to be closely related to equity market factors (Huang and Kong, 2003) while high-grade bonds are more responsive to treasury yields. Kwan (1996) finds that individual firm yield spread changes are negatively related to both contemporaneous and lagged equity returns of the same firm.…”

“…Similarly, Delianedis and Geske (2002) attribute credit spreads to taxes, jumps, liquidity and market risk. Factors associated with the equity premium include the Fama and French (1996) 'High-minus-Low' (HML) factor, found by Huang and Kong (2003) to account for a significant component of low-grade credit spread changes. The significance of Fama-French factors is also supported by Joutz et al (2001), who conclude that credit spreads are determined by both default risk and systematic market risk.…”

Forecasting High-Yield Bond Spreads Using the Loan Market as Leading Indicator

“…Elton et al (2001) attribute the non-default part of the risk premium to state taxes and factors commonly associated with equity premium. Huang and Kong (2003) use daily trading data to explain the spread variation on investment grade and HY bonds with an Autoregressive Conditional Heteroscedasticity (ARCH) model. They find that the return on an equity market index provides valuable information in forecasting credit spread for the next trading day as the estimated coefficients of lagged Russell 2000 index returns are found to be significantly negative in credit spread equation.…”

European Asset Swap Spreads and the Credit Crisis

“…For this reason, previous related studies use stock market returns and various volatility indexes to proxy for the firms' value and volatility Huang and Kong 2003;Aretz and Pope 2013). When (past) realized stock market returns are higher (i.e.…”