Yield Curve Factors' Exposure of the U.S. Credit Markets: Re-Testing the Extreme Sensitivities through the Quantile Approaches

Abstract

Yield Curve Factors’ Exposure of the U.S. Credit Markets: Re-Testing the Extreme Sensitivities through the Quantile Approaches This study examines the changing aspects of the relationship between the yield rate, its factors, and the credit default swap spreads (CDS), a type of credit derivative contract. The dynamics of the relationship between the yield rate and the CDS spreads i.e. explored by decomposing the yield rate into its long, short and medium-term factors namely the level, slope and curvature factors. The impact of any changes in the yield curve factors is analyzed on the sector-wise CDS spreads through varying market conditions. The data series is based on the CDS spreads of ten U.S. industrial sectors from December 2007 to August 2018. The factors of the yield rate are obtained from the zero-coupon yields of the U.S. Treasury, ranging across eleven different maturities i.e. for 1, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20 and 30 years. The quantile approaches are used to test the sensitivities among the yield curve factors and the sector-wise CDS spreads. The validity of the Merton model is checked by using the returns for the S&P 500 index and the crude oil-based volatility index OVX. The results for the quantile framework reveals that the long-term yield curve factor is the significant determinant of the CDS spreads for most of the sectors regardless of the market state i.e. bullish or bearish and the relationship is inverse in nature. Conversely, the slope factor does not exhibit any significant impact on the CDS spreads through any of the sectors or the market states. Additionally, the medium-term yield curve factor has a negatively significant explaining power for most of the sectors' CDS spreads specifically in the highest quantile i.e. in the bullish market state. The respective sector returns have a negatively significant impact on the CDS price while the oil volatility index does not exhibit any significant influence on the CDS premia under any market state. The overall results suggest that the sector-wise CDS spreads respond disproportionately to extreme variations in the yield rate and its factors, which are different in magnitude and propagation time. This study also identifies differences in the way the CDS prices respond to a single yield rate as compared to its factors. While the results of the consumer services sector show most sensitivity to the downward shocks, the financial sector results indicate a high response to extreme positive shocks, irrespective of xii changes in the yield rate or its factors. The technology sector findings show minimum sensitivity to the extreme yield rate fluctuations in both downward and upward spill overs. The consumer goods CSD results correspond the least sensitivity to the extreme upward movements the level, slope or curvature factors. The findings of the study have important implications for various economic agents related to policy development and portfolio risk management through market busts and booms. According to the findings, the diversification benefits aree greater when the economy was expanding, i.e., when the long-term yield rate (slope) increased (upper quantiles), especially for the financial sector. Financial institutions can also make hedging decisions based on these findings. Conversely, for most of the industrial sectors, there are limited diversification benefits when the market state was either bearish or normal (lower- or mid-quantiles), as then the changes in the yield curve factors (specifically slope and curvature) exhibited a weak relationship with CDS premia. These findings may aid policymakers and institutional investors in devising relevant policies for the development and restructuring of a derivative market by providing insight into the pricing dynamics of sector-wise CDS and yield rate fluctuations. In future research, more variables could be used by employing empirical approaches that further lead to an in-depth analysis of the nexus between CDS premia and yield rate factors. This study could be extended to other time series and regions. Keywords: Credit default swap; credit risk; term structure; quantile regression; quantile-on-quantile; VAR for VaR