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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
What Drives the Cross-Section of Credit Spreads?: A Variance Decomposition Approach
Yoshio Nozawa
Abstract

I decompose the cross-sectional variation of the credit spreads for corporate bonds into changing expected returns and changing expectation of credit losses with a model-free method. Using a log-linearized pricing identity and a vector autoregression applied to micro-level data from 1973 to 2011, I find that the expected credit loss component and the excess return component each explains about half of the variance of the credit spreads. Unlike the market-level findings in Gilchrist and Zakrajsek (2012), at the firm level, the expected credit loss is volatile and affects the firms' investment decision more than the expected excess returns.


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Yoshio Nozawa, What Drives the Cross-Section of Credit Spreads?: A Variance Decomposition Approach, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2014-62, 02 Aug 2014.
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Keywords: Credit risk; fixed income; variance decomposition; credit spread
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