An Empirical study of US Corporate Credit Spreads

Joy Pathak
December 15, 2011
Abstract
This paper presents an analysis of the factors that affect US corporate credit spreads. Using data
from Bloomberg we investigate the various determinants that cause changes in credit spreads of
US corporate firms. As previous research has shown, the variables that should be based on
theory determine credit spread changes have limited explanatory power. Our study breaks apart a
range of variables into three different sections and analyzes them individual in the groups and
together using multiple regressions. We investigate the spot rate, interest rate volatility and slope
for the interest rate effects and find strong relationships between spot rate and slope with credit
spreads. For the effects of volatility and market uncertainty we find strong relationships between
credit spreads and market volatility proxied by VIX and firm volatility proxied by an average of
Call and Put implied volatility. TED spreads, SPX and RTY returns show strong relationships
between macro-economic variables and credit spreads. Implied default correlations in the
Investment Grade and High Yield market also show a strong positive relationship with credit
spreads. Our research investigates certain macro-economic variables that have not been
researched before and re-establishes previous findings for other variables post-2007 crisis.

Electronic copy available at: http://ssrn.com/abstract=1989012

Introduction

Corporate credit risk and the premium of the spread for that risk has become one of the most
important topics in finance ever since the credit crisis of 07/08. The growth of the credit
derivatives market illustrates the attempt of the financial market to measure and possibly control
that risk. This paper presents an analysis of what factors affect credit spreads and what truly are
the components of CDS prices.
There are three main activities that a central bank is interested in doing; monetary policy,
financial stability of the markets, and asset management. When it comes to monetary stability,
credit spreads are studied due to their role in the overall transmission system of the financial
markets. In order to understand the functioning of monetary policy measures, monetary
authorities analyse the interdependence between corporate bonds, government bonds and money
markets. Thus, they can obtain an insight into how the impulses of monetary policy action are
transmitted across financial markets and on towards the real economy. Furthermore, there is
evidence that corporate bonds possess leading indicator properties for the economic climate in
aggregate. So, it can be said that the information content of credit spreads makes them useful as
indicators for monetary policy. Since the crisis in August 1998, central banks have been
increasing their monitoring of potential sources of instability in financial markets. In this context,
the systemic risk in the banking sector is regularly observed. This key risk category is heavily
influenced by the development of aggregate credit risk among banks and financial institutions.
Despite the increasing importance of financial markets, credit risk is still the major component of
most banks activities. Here, corporate bond markets are an important data source, because data
on bank loans are difficult to collect.

Electronic copy available at: http://ssrn.com/abstract=1989012

Studies on corporate credit spreads by Gruber et al (2001) and Collin-Dufresne et al (2000) said
that a significant part of the movements in credit spreads of corporate bonds are explained by
much more than the expected default risk of the corporation as had been previously suggested.
Historically, in the United States, corporate bond markets have been much less liquid than both
government bonds and stocks. Corporate bonds are also taxed differently than government bonds
since they are taxed at the state level. Furthermore, Longstaff (1999) has argued that corporate
bond markets are illiquid and are thought to be incomplete. Thus, it seems likely that the credit
spread between corporate and government bonds may be only partly attributed to default risk. So
the residual difference between the observed credit spread and this measured default spread may
also be attributed to other factors such as taxes, liquidity, and market risks.
Collin-Dufresne et al (2000) regressed changes in the US corporate credit spreads on a range of
variables like leverage, economic environment indicators and volatilities. They found that a large
part of the dynamics of corporate credit spreads could still not be explained by these variables.
Gruber et al (2001) found that expected default risk only explains about 25% of the observed
credit spreads. Their research concluded that the risk in corporate bonds moved more with
changes in tax effects and a risk premium. They suggested that the risk in corporate bonds are
mostly systematic in nature and cannot be diversified away.
Ming (1998) performs an empirical analysis of emerging market bond spread determination. He
finds explanatory variables for the cross-country differences in bond spreads. He analyzes 4
groups of variables: Liquidity and solvency variables, macroeconomic fundamentals, external
shocks and dummy variables. He finds that the first two groups of factors influence emerging
market bond spreads. Liquidity and solvency variables such as debt-to-GDP ratio, debt-service-

Electronic copy available at: http://ssrn.com/abstract=1989012

ratio, net foreign assets and international reserves-to-GDP ratio are found to be significant and of
the expected sign. These variables capture the countrys ability to repay the debt.
Macroeconomic fundamentals such as the domestic inflation rate and terms of trade capture the
quality of the countrys economic policy which determines its future ability to service its debt.
This paper is organized as follows: Section 2 describes The Variables/Data and outlines the
hypothesis; Section 3 goes through the Results and Section 4 Concludes.

Variables and Hypothesis

Credit Spreads The financial term, credit spread is the yield spread, or difference
in yield between different securities, due to different credit quality. The credit spread reflects the
additional net yield an investor can earn from a security with more credit risk relative to one with
less credit risk. The credit spread of a particular security is often quoted in relation to the yield
on a credit risk-free benchmark security or reference rate. The benchmark is usually US
treasuries and the and the securities used for the study are US corporate bonds. The data is
gathered from Bloomberg.

Interest Rates:
Spot Interest Rate (

Longstaff and Schwartz (1995), state that the static effect of a higher

spot rate is to increase the risk neutral drift of the firm value process. A higher drift reduces the
probability of default, and in turn, reduces the credit spreads. A negative relationship is expected
between change in credit spread and interest rate. The spot rate is proxied using the 10 year US

treasury spot rate. This result compliments what is seen in the capital markets. During good
economic conditions investors are willing to take on more risk and sell their treasury bonds and
buy risky assets. This sell-off in the treasury market causes yields to rise. This risk on
environment wherein investor buy into corporate bonds leads to a decrease in the credit spreads
of the firms.
Changes in the slope of the Yield curve (

- The two most important factors driving the

term structure of interest rates are the level and slope of the term structure. If an increase in the
slope of the Treasury curve increases the expected future short rate, then by the same argument
as above, it should also lead to a decrease in credit spreads.
From a different perspective, a decrease in yield curve slope may imply a weakening economy. It
is reasonable to believe that the expected recovery rate might decrease in times of recession.8
Once again; theory predicts that an increase in the Treasury yield curve slope will create a
decrease in credit spreads. We define the slope of the yield curve as the difference between 10year and 2-year Benchmark Treasury yields.
Volatility of Interest Rates (

) Apart from changes in the level of the risk-free interest rate,

we also include its volatility. From a theoretical perspective this factor is motivated by Longstaff
and Schwartz (1995), who introduced stochastic interest rates to Mertons basic setup.
Furthermore, Collin-Dufresne et al (2001) report that squared changes of the yields of 10-year
government bonds add significant explanatory power to their models of credit spread changes in
the US market. The influence of volatility can be interpreted as a quantification of convexity, ie
the curvature in the interdependence between bond yields and bond prices. Concerning the sign
of the respective coefficient, it is not a priori clear if it should be positive or negative, ie if the

credit spread falls or rises as the yield volatility increases. Collin-Dufresne et al (2001) report
with regard to the squared yield of the 10-year government bonds negative coefficients for highrated corporate bonds with short maturities and positive coefficients for low-rated short term and
all long-term bonds. This result is consistent with respect to the structural model of default risk
with stochastic interest rates by Longstaff and Schwartz, where the impact of a change in the
yield volatility on the credit spread can be positive or negative. We use the Barclays Swaption
volatility index to proxy interest rate volatility.
Linear Regression 1:

Volatility
Option Volatility (

- Another factor that affects the credit spread according to the

structural approach is the volatility of the firm value. The price of an option increases with the
volatility of the underlying, because increasing volatility makes it more likely that the put option
will be exercised. In the present context a higher volatility implies that large changes of the
leverage become more likely. Hence the probability that the leverage ratio approaches unity, or
that the firm value falls below the face value of the debt and the firm defaults, increases. Again,
the analysis is not done on the basis of the leverage ratio, but we use the volatility of an
appropriate equity index, where we expect that a rise leads to an increase of the credit spread.
This prediction is intuitive: Increased volatility increases the probability of default. We use an
average of Put and Call option volatility to proxy firm level volatility.

 In addition to the firm level volatility the same effect can be

Market Volatility (

expected of market volatility. An increase in the overall market volatility should lead to higher
credit spreads. We use the VIX as a proxy for market volatility.
Linear Regression 2:

Macro-economic
Part A:
Business Climate The general business climate can have a significant effect on individual
firms. Obviously in a good economy with high GDP and no recession companies will flourish
with default probabilities coming down.
The expected recovery rate in turn should be a function of the overall business climate. Even if
the probability of default remains constant for a firm, changes in credit spreads can occur due to
changes in the expected recovery rate. To proxy business climate we look at the US Dollar index
(

, S&P (

and Russell 2000 (

returns. We hypothesize that with higher

returns and a higher value of the US dollar the corporate credit spreads of US firms should
tighten to reflect strong overall performance and balance sheets.

Ted Spreads

)- The TED spread is an indicator of perceived credit risk in the general

economy.[1] This is because T-bills are considered risk-free while LIBOR reflects the credit risk
of lending to commercial banks. When the TED spread increases, that is a sign that lenders
believe the risk of default on interbank loans (also known as counterparty risk) is increasing.
Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe

investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the
TED spread decreases.
Linear regression 3:

Part B:
Implied Default Correlation - The tendency for firms' defaults to cluster is a widely accepted
phenomenon in corporate bond and credit derivatives markets. The general observation is that
regardless of the state of the economy there is some average number of firms that default each
period, and intermittently there are sharp increases in the number of defaults. These spikes, or
default clusters, are not persistent and the number of defaults readily reverts to the pre-cluster
average. Modelling this phenomenon plays a prominent role in bond risk management and in the
valuation of credit derivatives, such as collateralized debt obligations (CDOs), and it is this
phenomenon that is typically modelled by a default correlation parameter. We show that
corporate bond credit spreads are increasing in default correlation, as implied from the CDO
market. We gather data from the Morgan Stanley internal database on implied default
correlations in the high yield and investment graduate tranche markets.
Linear regression 4:

Empirical Testing and Data

All the data was collected from Bloomberg. The data set is from 2009 to present with daily frequency
for all variables. SAS and SPSS were used to conduct all the statistical analysis. The descriptive
statistics can be seen in Table 1 for all the data used. The primary and secondary variables are shown.
Only US corporates were chosen.

Table 1: Descriptive Statistics

Std.
Minimu Maximu
N

Deviatio
Sum

Mean

Skewness

Statist
ic
CDS Spreads

Kurtosis

Statist Std. Statist Std.

Statistic Statistic Statistic Statistic Statistic

ic

688 263.329 1052.590 309900.1 450.4363 206.8232 1.224

7

767

03

966

Error
.093

ic
.219

Error
.186

Date

688 05-Jan- 13-Sep- *

2009

USGG10YR

688

1.9183

2011 **:**:**

2010

.093 -1.215

.186

.093 -.378

.186

19

3.9859 2187.813 3.179962 .4439838 -.565

Index
USGG2YR

10-May- 6851:58: -.008

9
688

.1688

1.3980 504.5768 .733397 .2482896 -.257

.093 -.593

.186

688

1.4917

2.9124 1683.237 2.446566 .3209773 -.775

.093 -.350

.186

.473

.093 -.678

.186

688 10.5700 133.5100 23641.37 34.36245 27.41243 1.853

.093 2.187

.186

.093

.542

.186

.093 -.489

.186

.093 3.684

.186

.093 -.774

.186

.093 2.534

.186

Index
Slope

1
Dollar Spot

688 72.9330 89.1050 54727.74 79.54614 3.886716

Index
Ted Spread

40

00
VIX Index

90

688 676.530 1363.610 762568.6 1108.384 160.4047 -.473

0

SPX Return

688 14.6200 56.6500 17527.70 25.47630 8.747419 1.147

00

SPX Index

687 -6.6634

600

680

026

7.0758 30.2513 .044034 1.403752 -.163

5

RTY Index

688 343.260 865.2900 446843.0 649.4812 125.0072 -.196

0

RTY Return

687 -8.9095

800

21

224

8.4002 43.9583 .063986 1.907586 -.045

6

BBOX Index

688

83.98

122.45 69025.65 100.3280 8.23730

.534

.093 -.522

.186

Implied Vol

688

.0000 96.0973 28784.94 41.83858 15.12971 1.331

.093 1.366

.186

.629

.100

.660

.199

.545

.100 -.737

.199

32
Implied

51

600 25.4052 65.7603 26679.86 44.46644 5.169471

Correlation

93

HY
Implied

600 32.4068 65.5762 26380.61 43.96768 7.278448

Correlation IG
Valid N

30

599

(listwise)

Results

Interest Rates:
Consistent with the empirical findings of Longstaff and Schwartz ~1995 and Duffee ~1998!, we
find that an increase in the risk-free rate lowers the credit spread for all bonds. A negative
correlation with a coefficient of -0.289 is observed between the 10 year spot rate and credit
spreads.
The slope of the term structure displays a strong negative relationship of -0.675 as hypothesized.
An increase in the slope creates a decrease in credit spreads.

The interest rate volatility as proxied by a swaption volatility index does not show a significant
correlation. This is consistent with the study of Longstaff and Shawrtz. They were not able to see
a significant relationship and hypothesized as us that the relationship can be positive or negative.

Volatility:
Implied volatility showed a strong positive (0.840) relationship with credit spreads. As the
implied volatility of a firm increases the option price increases which would suggest the market
is pricing in higher uncertainty associated with the firm. This would be directly related to the
credit spreads as higher uncertainty would lead to higher credit spreads.
The relationship of market volatility and firm level volatility should generally be similar. This
relationship is further confirmed with the strong positive relationship of 0.927 correlation seen
between market volatility and credit spreads.
Macro-economic
Part A:
US Dollar index showed a positive relationship between credit spreads and the macro-economy.
This rejected our hypothesis of a negative relationship in which a well performing economy
should lead to a higher dollar and a lower credit spread for US firms. A reason behind this could
be that although corporations were performing well and reporting record breaking earnings while
the economy was still recovering from the recession leading to speculative bets on the dollar
pressuring it downwards. This lead to tightening in credit spreads while the dollar weakened.
Federal policies and lowering of interest rate might have led to a lower dollar value while at the

same time corporations strengthened by building up their balance sheets leading to lower credit
spreads.
TED spread is mentioned previously is an indicator of perceived credit risk in the general
economy. Out of all the variables chosen TED spread has the most direct relation to credit
spreads. This was further proven by the strong correlation shown at 0.881. As credit risk in the
economy increases credit spreads of the firms increase.
The last two variables tested in part A were the SPX And RTY index returns. SPX and RTY
index returns show a negative correlation of -0.832 and -0.798 respectively. This further proves
that with a healthy economy and strong macro-economic fundamentals that lead to higher returns
in the capital markets should lead to a tightening of credit spreads.
Part B:
The implied correlation in the defaults in the HY and IG trance markets show a correlation of
0.430 and 0.779 respectively. This is in line with our hypothesis as we expected an increase in
default correlation to be directly proportional to a widening of credit spreads. The HY
relationship does not show as strong of a relationship as IG because of potential volatility in the
HY market.

Conclusion

We investigate changes in US corporate credit spreads. As mentioned corporate credit risk has
become quite a hot topic since the crisis of 2007. The growth of the credit default swap market
has grown significantly. This paper goes into a deep investigation of how credit spreads are

affected by a range of variables. As previous research has shown, the variables that should be
based on theory determine credit spread changes have limited explanatory power. Our study
breaks apart a range of variables into three different sections and analyzes them individual in the
groups and together using multiple regressions. We investigate the spot rate, interest rate
volatility and slope for the interest rate effects and find strong relationships between spot rate
and slope with credit spreads. For the effects of volatility and market uncertainty we find strong
relationships between credit spreads and market volatility proxied by VIX and firm volatility
proxied by an average of Call and Put implied volatility. TED spreads, SPX and RTY returns
show strong relationships between macro-economic variables and credit spreads. Implied default
correlations in the IG and HY market also show a strong positive relationship with credit
spreads. Our research investigates certain macro-economic variables that have not been
researched before and re-establishes previous findings for other variables post-2007 crisis.
We believe that it would be very useful to understand in a deeper fashion how volatility affects
credit spreads. For further research we would like to understand how the individual firm option
volatility skew affects the firms credit spreads. We also plan to investigate how credit spreads of
different ratings react to the variables in this study. We believe that our study should lay the path
to further research in this field as this paper is on the few papers that has studied credit spreads
post 2007 crisis.

ACKNOWLEDGEMENTS
We are very grateful to Dr. Jim Gatheral and Dr. Simina Farcasiu. We would also like to thank
Ken Abbott and Dr. Andrew Lesniewski for their valuable suggestions.

REFERENCES

Longstaff, Francis A., and Eduardo Schwartz, 1995, A simple approach to valuing risky fixed
and f loating rate debt, Journal of Finance 50, 789821.
Collin-Dufresne, P., and R. Goldstein. Do Credit Spreads Reflect Stationary Leverage Ratios?
Journal of Finance, 56 (2001), pp. 1929-1957.
Duffee, Gregory R., 1998, The relation between treasury yields and corporate bond yield
spreads, Journal of Finance 53, 22252241.
Merton, R. C., 1972, Theory of Rational Option Pricing, Bell Journal of Economics and
Management Science, 4, Spring, pp. 141-183.
Elton, E., and Gruber, M., Agrawal, D., Mann, C., 2000, Explaining the Rate Spread on
Corporate
Bonds, NYU Working Paper, September, 1999, forthcoming, Journal of Finance.

APPENDIX A
Interest Rate
Descriptive Statistics
Mean
CDS Spreads

Std. Deviation

450.436303

206.8232966

688

USGG10YR Index

3.179962

.4439838

688

Slope

2.446566

.3209773

688

BBOX Index

100.3280

8.23730

688

Correlations
USGG10YR
CDS Spreads
Pearson Correlation

Slope

BBOX Index

CDS Spreads

1.000

-.289

-.675

.171

USGG10YR Index

-.289

1.000

.837

.589

Slope

-.675

.837

1.000

.322

.171

.589

.322

1.000

.000

.000

.000

USGG10YR Index

.000

.000

.000

Slope

.000

.000

.000

BBOX Index

.000

.000

.000

CDS Spreads

688

688

688

688

USGG10YR Index

688

688

688

688

Slope

688

688

688

688

BBOX Index

688

688

688

688

BBOX Index
Sig. (1-tailed)

Index

CDS Spreads

Coefficients

Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Beta

59.107

343.602

21.650

-867.995
4.286

BBOX Index
a.

Std. Error

1051.436

USGG10YR Index
Slope

Coefficients
t

Sig.

17.789

.000

.738

15.871

.000

25.570

-1.347

-33.946

.000

.675

.171

6.350

.000

Dependent Variable: CDS Spreads

b.

Volatility
Descriptive Statistics
Mean
CDS Spreads

Std. Deviation

450.436303

206.8232966

688

VIX Index

25.476308

8.7474199

688

Implied Vol

41.838580

15.1297151

688

Correlations
CDS Spreads
Pearson Correlation

Sig. (1-tailed)

CDS Spreads

VIX Index

Implied Vol

1.000

.840

.927

VIX Index

.840

1.000

.905

Implied Vol

.927

.905

1.000

.000

.000

VIX Index

.000

.000

Implied Vol

.000

.000

CDS Spreads

688

688

688

VIX Index

688

688

688

Implied Vol

688

688

688

CDS Spreads

Coefficients

Standardized
Model

Unstandardized Coefficients

Coefficients

Sig.

B
1

(Constant)

Std. Error

-80.306

9.150

.103

.795

12.623

.460

VIX Index
Implied Vol

Beta
-8.777

.000

.004

.129

.897

.923

27.451

.000

a. Dependent Variable: CDS Spreads

Macro-Economic
Descriptive Statistics
Mean
CDS Spreads

Std. Deviation

450.436303

206.8232966

688

Dollar Spot Index

79.546140

3.8867163

688

Ted Spread

34.362456

27.4124390

688

SPX Index

1108.384680

160.4047026

688

RTY Index

649.481221

125.0072224

688

Correlations
CDS Spreads
Pearson Correlation

Sig. (1-tailed)

CDS Spreads

Dollar Spot Index

Ted Spread

SPX Index

RTY Index

1.000

.457

.881

-.832

-.798

Dollar Spot Index

.457

1.000

.623

-.672

-.617

Ted Spread

.881

.623

1.000

-.751

-.696

SPX Index

-.832

-.672

-.751

1.000

.990

RTY Index

-.798

-.617

-.696

.990

1.000

.000

.000

.000

.000

Dollar Spot Index

.000

.000

.000

.000

Ted Spread

.000

.000

.000

.000

SPX Index

.000

.000

.000

.000

RTY Index

.000

.000

.000

.000

CDS Spreads

688

688

688

688

688

Dollar Spot Index

688

688

688

688

688

Ted Spread

688

688

688

688

688

SPX Index

688

688

688

688

688

CDS Spreads

Correlations
CDS Spreads
Pearson Correlation

Sig. (1-tailed)

CDS Spreads

Dollar Spot Index

Ted Spread

SPX Index

1.000

.457

.881

-.832

-.798

Dollar Spot Index

.457

1.000

.623

-.672

-.617

Ted Spread

.881

.623

1.000

-.751

-.696

SPX Index

-.832

-.672

-.751

1.000

.990

RTY Index

-.798

-.617

-.696

.990

1.000

.000

.000

.000

.000

Dollar Spot Index

.000

.000

.000

.000

Ted Spread

.000

.000

.000

.000

SPX Index

.000

.000

.000

.000

RTY Index

.000

.000

.000

.000

CDS Spreads

688

688

688

688

688

Dollar Spot Index

688

688

688

688

688

Ted Spread

688

688

688

688

688

SPX Index

688

688

688

688

688

RTY Index

688

688

688

688

688

CDS Spreads

Coefficients

Standardized
Unstandardized Coefficients
Model
1

RTY Index

B
(Constant)

Std. Error

3166.051

119.869

-20.881

.941

Ted Spread

4.531

SPX Index
RTY Index

Dollar Spot Index

Coefficients
Beta

Sig.

26.413

.000

-.392

-22.191

.000

.154

.601

29.474

.000

-1.914

.152

-1.484

-12.618

.000

1.403

.174

.848

8.071

.000

a. Dependent Variable: CDS Spreads

Macro-economic Implied Correlations

Descriptive Statistics

Mean
CDS Spreads

Std. Deviation

450.905113

215.9712259

600

Implied Correlation HY

44.466449

5.1694715

600

Implied Correlation IG

43.967688

7.2784482

600

Correlations

CDS Spreads
Pearson Correlation

Sig. (1-tailed)

CDS Spreads

Implied

Implied

Correlation HY

Correlation IG

1.000

.430

.779

Implied Correlation HY

.430

1.000

.382

Implied Correlation IG

.779

.382

1.000

.000

.000

Implied Correlation HY

.000

.000

Implied Correlation IG

.000

.000

CDS Spreads

600

600

600

Implied Correlation HY

600

600

600

Implied Correlation IG

600

600

600

CDS Spreads

Coefficients

Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Std. Error

-776.024

49.446

Implied Correlation HY

6.488

1.130

Implied Correlation IG

21.344

.803

a. Dependent Variable: CDS Spreads

Coefficients
Beta

Sig.

-15.694

.000

.155

5.741

.000

.719

26.589

.000