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.

The determinants of sovereign credit spread changes in the Euro-zone

“…In addition, they find that stock returns, the volatility of stock returns and liquidity drive a significant influence in credit spread changes. Huang and Kong (2003) examine the determinants of corporate bond credit spreads using optionadjusted spreads for nine Merrill Lynch corporate bond indexes, and confirm that credit spread changes for high yield bonds are more closely related to equity market factors than to macroeconomic factors. Codogno et al (2003) highlight the role of the international risk in determining spreads against Germany, and conclude that the risk of default is small but an important component of yield differentials because it imposes the market discipline in countries' fiscal policies.…”

Time series patterns in credit ratings

“…9 For example, see Connolly et al (2005), Ang et al (2006), and Corrado and Miller (2006). 10 Collin-Dufresne et al (2001) and Huang Kong (2003) investigate the association between changes in the VIX as a proxy for market risk and changes in bankruptcy risk quantities. Table 1 The …”

Option‐Adjusted Delta Credit Spreads: a Cross‐Country Analysis

“…28 The 'lagging' indicator is a weighted average of average duration, inventory/sales ratio, labor cost per unit ratio, prime rate, loans, credit/income ratio, and CPI of services. 29 Huang and Kong (2003) follow the same approach. 30 The UK 'leading' indicator is a weighted average of order book, output volume, consumer confidence, house starts, 31 The leading indicator is built using Handesblatt information and is a weighted average of industrial confidence, consumer confidence, industrial production, monetary aggregates, harmonised inflation, and curve.…”

“…This section outlines an empirical specification that includes a selected number of the described regressors. Following Huang and Kong (2003), we select them from a larger set to perform a parsimonious estimate.…”