Credit Spread Changes within Switching Regimes

by Olfa Maalaoui of HEC Montreal,
Georges Dionne of HEC Montreal, and
Pascal François of HEC Montreal

February, 12, 2009

Abstract: Many empirical studies on credit spread determinants consider a single-regime model over the entire sample period and find limited explanatory power. We model the credit cycle independently from macroeconomic fundamentals using a Markov regime switching model. We show that accounting for endogenous credit cycles enhances the explanatory power of credit spread determinants. The single regime model cannot be improved when conditioning on the states of the NBER economic cycle. Furthermore, the regime-based model highlights a positive relation between credit spreads and the risk-free rate in the high regime. Inverted relations are also obtained for some other determinants.

JEL Classification: C32, C52, C61, G12, G13.

Keywords: Credit spread, switching regimes, market risk, liquidity risk, default risk.

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