Credit Spread Changes within Switching Regimes

Abstract

Empirical studies on credit spread determinants are predicated on the presence of a single-regime over the entire sample period and thus find limited explanatory power. We show that a single regime model hides the fact that the explanatory variables take on different loadings across changing patterns in credit spreads. We capture these hidden effects by modeling endogenous (rating-specific) regimes for credit spreads. We find that in a two regime-based model traditional determinants have significant explanatory power consistent with the prediction of structural models, yet their importance changes across regimes -- some variables have their effects strengthen, weaken or even reverse signs across regimes. We also investigate the differing behavior of these loadings across different specifications of the economic cycle and find that endogenous regimes best capture the hidden effects of these variables with the highest explanatory power for the same set of variables.

Keywords: Credit spread, Markov switching regimes, market risk, liquidity risk, default risk, credit cycle, NBER economic cycle.

JEL Classification: C32, C52, C61, G12, G13