Abstract:
Recent theoretical models including the closed- form valuation model of
Longstaff and Schwartz (1995) predict that credit spreads are driven by
both an asset and interest rate factor. In empirical studies the credit spread
may be expressed as either the difference between, or ratio of, the risky
bond to a riskless bond. Using a daily sample of non-callable Australian
dollar denominated Eurobonds it is found, consistent with theory, that
changes in credit spreads are negatively related to both changes in the
return on All Ordinaries stock Index and changes in the Government
bond yield. Interestingly, the ratio measure - termed a relative credit
spread - tends to be statistically more significant than the alternate measure
based upon the difference - termed an actual credit spread. However,
it is shown that this result is spurious and due to the way in which relative
credit spreads are constructed. Noting Duffee's (1998) warning against
using callable bonds, the use or only non-callable Eurobonds provides a
cleaner result when compared with tests conducted by Longstaff and
Schwartz (1995).
