The determinants of credit spread returns

Jouke Hottinga and Machiel Zwanenburg

Jouke Hottinga is a risk manager at Aegon (NL). At the time of writing Machiel Zwanenburg was a quantitative researcher at Robeco Asset Management. He has been a risk manager at Robeco since July 2003.

In this chapter, we will consider the determinants of credit spread return, which is driven by both the level of and changes to the credit spread. This is important because if the credit spread of a bond increases, the yield of the bond will increase, resulting in a decrease in the bond’s market value. Information on the factors that drive the credit market can be used in different situations. Possible applications are the forecasting of the return on credit bonds, the measurement (and attribution) of the risk of credit portfolios and the attribution of portfolio returns in a performance measurement context. Although we restrict ourselves in this document to the determinants of credit spread returns on credit bonds, we briefly describe to what extent our results are applicable to credit derivatives.

Figure 1 depicts the development of credit spreads over the last 14 years. We notice that there is a high level of variation in the credit spread, particularly during the most recent

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