Explaining Credit Spread Changes

Credit risk is also the subject of this article by Huang and Kong. There are numerous credit risk models in which the relevant stochastic variables for pricing a risky bond are obtained from the term structure of interest rates, and perhaps from firm-level capital structure data. In this article, the authors look at option-adjusted spreads on corporate bond indexes for different credit ratings classes. They find that term structure variables alone are limited in their ability to explain yield spreads, but adding macroeconomic variables, like an index of leading economic indicators, and equity market variables, including the return on the Russell 2000 index and the Fama-French “high minus low” factor, can contribute significant explanatory power, especially for lower rated bonds.