Determinants of Aggregate Credit Spreads in Different Volatility Environments

Abstract

This paper identifies variables that may be related to changes in credit default swap indices, and studies whether these relationships are affected by market volatility. Credit default swap indices are portfolios made up of many credit default swaps, allowing investors to express their views on the overall credit market rather than trading one or two individual credits. As markets emerge from a period of persistently low volatility today, the study of the relationship between volatility and fluctuations in these aggregate credit indices is particularly relevant. This paper finds empirical evidence that part of the day-to-day movement of CDX North America Investment Grade and High Yield indices can be explained by interest rates and financial factors. Further, the relationship between these variables and the indices varies with differing levels of volatility (measured by the VIX). For instance, the paper shows that while interest rates tend to compress spreads in high volatility, they in fact tend to widen spreads in low volatility. Additionally, this paper seeks to explain this observed difference between the spread behavior in low and high volatility, finding some evidence that economic data that is much better or much worse than expectations (as measured by changes in the Citi economic surprise index) explains part of the divergence.