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

by Jing-zhi Huang of Pennsylvania State University & New York University, and
Weipeng Kong of Pennsylvania State University

Fall 2003

Abstract: This is an examination of the determinants of corporate bond credit spreads using both weekly and monthly option-adjusted spreads for nine Merrill Lynch corporate bond indexes from January 1997 through July 2002. 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. These three variables plus the interest rate level, the historical interest rate volatility, the yield curve slope, the Russell 2000 index return, and a high-minus low factor together can explain more than 40% of credit spread changes for five bond indexes. These eight variables together can explain 67.68% and 60.82% of credit spread changes for the B and Bb-rated indexes. The 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.

Published in: Journal of Derivatives, Vol. 11, No. 1, (Fall 2003), pp. 30-44.

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

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