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Credit Spread determined by a single common variable

Understanding Credit Spread Markets

I describe results of empirical studies of historical spreads in the
corporate bond market and show how spread changes, regardless of
credit rating, are largely determined by a single common variable. In
addition, I calculate the component of corporate credit spreads due to
default probability and report analyses of the residual spreads as
functions of credit quality and duration.

Analysis of spread changes for other spread markets (e.g.
asset-backeds, emerging markets, etc.) reveal a large, but smaller,
degree of spread co-movement across sectors and indicate that sector
spreads trend and mean revert on roughly similar time scales. That is,
spread changes trend in the short term (under two years) and
mean-revert over longer periods.

That information, along with the CAPM and our strategists' monthly
outlooks, was used to construct a cross-sector asset allocation model
that consistently outperformed a benchmark portfolio in ten years of
out-of-sample testing.

Terry Benzschawel (Citigroup Global Markets)


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