Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indices

Abstract

This paper revisits the question of the determinants of corporate bond credit spreads using some new explanatory variables with both weekly and monthly option-adjusted credit spreads of corporate bond indices from Merrill Lynch. We find that among the new variables, the interest rate historical volatility, the Russell 2000 index historical return volatility and Conference Board leading and coincident economic indices have significant power in explaining credit spread changes, especially for high yield bond indices. Furthermore, these four variables plus the interest rate level, the yield curve slope, the Russell 2000 index return, and the Fama-French [1996] high-minus-low factor return could explain more than 40% of credit spread changes in 5 out of 9 rating/maturity indices. In particular, these variables could explain 67.68% of the variation in B rated index credit spreads and 60.82% of the variation in BB rated index credit spreads. The overall explanatory power on credit spread changes achieved here is a notable improvement over most previous studies using either option-adjusted index spreads or individual corporate bond spreads. Our analysis confirms that high-yield credit spread changes are more closely related with equity market factors and also provides evidence in favor of incorporating macroeconomic risk factors into credit risk models.