Variables: Predicting Credit Spreads

Variables:

The dependent and independent variables were collected for each month between July 1988 and January 1999 (May 1991 - Jan 1999 for AAA and BBB 10-yr spreads). All changes described below are month-to-month. The following tables describe the variables used in the analysis. Please note that, in the second table, the expected correlation is to the credit spread, not the price of credit-risk securities. In other words, an increase in a positively correlated variable would cause an increase in the credit spread, or a drop in credit-risk security prices.

Dependent Variables
Independent Variables

Dependent Variables

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Dependent Variable

Source

Form

Explanation

Credit spread - aggregate index

Datastream

Spread (yield) change

Value-weighted index of the middle yield on U.S. corporate bonds less the yield on the current 10-year Treasury. The index includes all maturities and investment grade credit ratings.

Credit spread - AAA, 10-year

Bloomberg

Spread (yield) change

Value-weighted index of the middle yield on 10-year corporate bonds rated A3 and above less the yield on the current 10-year Treasury.

Credit spread - BBB, 10-year

Bloomberg

Spread (yield) change

Value-weighted index of the middle yield on 10-year corporate bonds rated BBB less the yield on the current 10-year Treasury.

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Independent Variables

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Independent Variable

Source

Form

Explanation

Expected Correlation

Lagged credit spreads

See above

Yield change

Is the autocorrelation between current and lagged credit spreads predictive?

Unknown

S&P 500 Composite Index

Datastream

Percent change (monthly return)

The equity market could be relevant to corporate bond credit spreads in several ways: as an alternate investment, as a measure of capital markets investment levels, as a yield-producing security.

Negative. The equity market as an alternate to fixed income investment is the most plausible in today's environment.

S&P 500 volatility

Datastream

6-month percent change (calc'd from percent change of Index levels)

See above.

Positive. Increases in equity price volatility would likely cause risk averse investors to change to the relative safety of fixed income securities.

S&P 500 dividend yield

Datastream

Yield change

See above.

Positive. Increases in the dividend yield makes the equity market more attractive as a yield-bearing investment.

Interest rates - yield on the current three month T-bill

Datastream

Yield

Are there any specific effects of the interest rate level on credit spreads?

Unknown

Bond volatility

Datastream

6-month yield change (calc'd from the month-to-month yield change on current Treasury)

Volatility is used as a measure of risk. As actual prices are not applicable from on-the-run to when-issued Treasuries, yield was used in the calculation.

Negative. The volatility of Treasury prices can be interpreted as a measure of the risk for the entire fixed income market. As volatility increases, the risk averse investor will withdraw his exposure.

Yield curve changes

(6mo- 3mo, 1yr-6mo, 2-1, 3-2, 5-3, 10-5, 30-10)

Datastream

Spread (yield) change

Many economists believe that an upward-sloping yield curve (higher rates for longer maturities) indicates higher interest rates in the future.

Positive. The expectation of higher interest rates in the future would suggest lower prices (higher spreads) on fixed income securities. The degree to which yield curve changes are captured in Treasury yields versus credit spreads is unknown.

Swap spreads

Datastream

Spread (yield) change

The swap rate is a proxy for the AA credit rate. As the swap market is significantly deeper and more liquid than that for corporate bonds, swap rates may provide a forward indication of the direction of credit spreads.

Positive. As swap spreads increase, so should credit spreads.

TED (Treasury - Eurodollar) spreads

Datastream

Spread (yield) change

TED spreads capture the credit rating of the United States economy.

Negative. The TED spreads used in this analysis are always negative (T - ED). A positive change in the spread is a tightening of the spread. If TED spreads tighten, the U.S. economy is attractive to foreign investment. Credit spreads should tighten.

Consumer confidence, Consumer expectations, Consumer confidence - present situation

Datastream

Percent change

Consumer confidence is a forward indicator of consumer spending and, therefore, GDP growth.

Negative. Increases in consumer confidence should indicate that there is more investment capital available. Thus, credit spreads should tighten.

Industrial production

Datastream/ Bloomberg

Percent change

Industrial production is a forward indicator of GDP growth.

Unknown. Increases in this measure could mean a healthy U.S. economy or be an inflationary warning. The effect on credit spreads would vary.

See the model.

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Dependent Variable	Source	Form	Explanation
Credit spread - aggregate index	Datastream	Spread (yield) change	Value-weighted index of the middle yield on U.S. corporate bonds less the yield on the current 10-year Treasury. The index includes all maturities and investment grade credit ratings.
Credit spread - AAA, 10-year	Bloomberg	Spread (yield) change	Value-weighted index of the middle yield on 10-year corporate bonds rated A3 and above less the yield on the current 10-year Treasury.
Credit spread - BBB, 10-year	Bloomberg	Spread (yield) change	Value-weighted index of the middle yield on 10-year corporate bonds rated BBB less the yield on the current 10-year Treasury.

Independent Variable	Source	Form	Explanation	Expected Correlation
Lagged credit spreads	See above	Yield change	Is the autocorrelation between current and lagged credit spreads predictive?	Unknown
S&P 500 Composite Index	Datastream	Percent change (monthly return)	The equity market could be relevant to corporate bond credit spreads in several ways: as an alternate investment, as a measure of capital markets investment levels, as a yield-producing security.	Negative. The equity market as an alternate to fixed income investment is the most plausible in today's environment.
S&P 500 volatility	Datastream	6-month percent change (calc'd from percent change of Index levels)	See above.	Positive. Increases in equity price volatility would likely cause risk averse investors to change to the relative safety of fixed income securities.
S&P 500 dividend yield	Datastream	Yield change	See above.	Positive. Increases in the dividend yield makes the equity market more attractive as a yield-bearing investment.
Interest rates - yield on the current three month T-bill	Datastream	Yield	Are there any specific effects of the interest rate level on credit spreads?	Unknown
Bond volatility	Datastream	6-month yield change (calc'd from the month-to-month yield change on current Treasury)	Volatility is used as a measure of risk. As actual prices are not applicable from on-the-run to when-issued Treasuries, yield was used in the calculation.	Negative. The volatility of Treasury prices can be interpreted as a measure of the risk for the entire fixed income market. As volatility increases, the risk averse investor will withdraw his exposure.
Yield curve changes (6mo- 3mo, 1yr-6mo, 2-1, 3-2, 5-3, 10-5, 30-10)	Datastream	Spread (yield) change	Many economists believe that an upward-sloping yield curve (higher rates for longer maturities) indicates higher interest rates in the future.	Positive. The expectation of higher interest rates in the future would suggest lower prices (higher spreads) on fixed income securities. The degree to which yield curve changes are captured in Treasury yields versus credit spreads is unknown.
Swap spreads	Datastream	Spread (yield) change	The swap rate is a proxy for the AA credit rate. As the swap market is significantly deeper and more liquid than that for corporate bonds, swap rates may provide a forward indication of the direction of credit spreads.	Positive. As swap spreads increase, so should credit spreads.
TED (Treasury - Eurodollar) spreads	Datastream	Spread (yield) change	TED spreads capture the credit rating of the United States economy.	Negative. The TED spreads used in this analysis are always negative (T - ED). A positive change in the spread is a tightening of the spread. If TED spreads tighten, the U.S. economy is attractive to foreign investment. Credit spreads should tighten.
Consumer confidence, Consumer expectations, Consumer confidence - present situation	Datastream	Percent change	Consumer confidence is a forward indicator of consumer spending and, therefore, GDP growth.	Negative. Increases in consumer confidence should indicate that there is more investment capital available. Thus, credit spreads should tighten.
Industrial production	Datastream/ Bloomberg	Percent change	Industrial production is a forward indicator of GDP growth.	Unknown. Increases in this measure could mean a healthy U.S. economy or be an inflationary warning. The effect on credit spreads would vary.