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

Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indexes We examine the question of the determinants of corporate bond credit spreads using both weekly and monthly option-adjusted spreads for nine corporate bond indexes from Merrill Lynch from January 1997 to July 2002. We find that the Russell 2000 index historical return volatility and the Conference Board composite leading and coincident economic indicators have significant power in explaining credit spread changes, especially for high yield indexes. Furthermore, these three variables plus the interest rate level, the historical interest rate volatility, the yield curve slope, the Russell 2000 index return, and the Fama-French [1996] high-minus-low factor can explain more than 40% of credit spread changes for five bond indexes. In particular, these eight variables can explain 67.68% and 60.82% of credit spread changes for the Band the BB-rated indexes, respectively. Our analysis confirms that credit spread changes for high-yield bonds are more closely related to equity market factors and also provides evidence in favor of incorporating macroeconomic factors into credit risk models.