A No-Arbitrage Analysis of Economic Determinants of the Credit Spread Term Structure
City University of New York, CUNY Baruch College - Zicklin School of Business
Frank Xiaoling Zhang
FEDS Discussion Paper No. 2005-59
Management Science, Forthcoming
This paper presents an internally consistent analysis of the economic determinants of the term structure of credit spreads across different credit rating classes and industry sectors. Our analysis proceeds in two steps. First, we extract three economic factors from 13 time series that capture three major dimensions of the economy: inflation pressure, real output growth, and financial market volatility. In the second step, we build a no-arbitrage model that links the dynamics and market prices of these fundamental sources of economic risks to the term structure of Treasury yields and corporate bond credit spreads. Via model estimation, we infer the market pricing of these economic factors and their impacts on the whole term structure of Treasury yields and credit spreads.
Estimation shows that positive inflation shocks increase both Treasury yields and credit spreads across all maturities and credit rating classes. Positive shocks on the real output growth also increase the Treasury yields, more so at short maturities than at long maturities. The impacts on the credit spreads are positive for high credit rating classes, but become negative and increasingly so at lower credit rating classes. The financial market volatility factor has small positive impacts on the Treasury yield curve, but the impacts are strongly positive on the credit spreads, and increasingly so at longer maturities and lower credit rating classes.
Finally, when we divide each rating class into two industry sectors: financial and corporate, we find that with in each rating class, the credit spreads in the financial sector are on average wider and more volatile than the spreads in the corporate sector. Estimation further shows that the term structure of credit spreads in the financial sector is more responsive to shocks in the economic factors.
Number of Pages in PDF File: 33
Keywords: Credit spreads, term structure, interest rates, macroeconomic factors, financial leverage, volatility, dynamic factor mode, Kalman filter
JEL Classification: E43, G12, G13
Date posted: March 21, 2005 ; Last revised: June 15, 2008