What Drives the Cross-Section of Credit Spreads?: A Variance Decomposition Approach

Abstract

I decompose the variation of credit spreads for corporate bonds into changing expected returns and changing expectation of credit losses. Using a log-linearized pricing identity and a vector autoregression applied to microlevel data from 1973 to 2011, I find that expected returns contribute to the cross-sectional variance of credit spreads nearly as much as expected credit loss does. However, most of the time-series variation in credit spreads for the market portfolio corresponds to risk premiums.