The Nonlinear Dynamics of Corporate Bond Spreads: Regime-Dependent Effects of Their Determinants
54 Pages Posted: 10 Apr 2019
Date Written: 2019
This paper studies the behavior of corporate bond spreads during different market regimes between 2004 and 2016. Applying a Markov-switching vector autoregressive (MS-VAR) model, we document that the dynamic impact of spread determinants varies substantially with market conditions. In periods of high volatility, systematic credit risk - rather than interest rate movements - contributes to driving up spreads. Moreover, while market-wide liquidity risk is not priced when volatility is low, it becomes a crucial factor during stress periods. Our results challenge the notion that spreads predominantly capture credit risk and suggest it must be reassessed during periods of financial distress.
Keywords: corporate bond spreads, regime dependency, Markov switching, vector autoregression, credit spread puzzle
JEL Classification: C32, C34, C58, G12
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