Exploring the Common Factors in the Term Structure of Credit Spreads,” Arizona State University working paper

This paper provides a factor analysis of the term structure of credit spreads. We show that credit spread innovations are subject to three common factors, two strong factors and one weak factor. A novelty is that our factors are extracted using canonical relations between credit spreads and a set of observable or estimated variables. This approach appears to estimate the factors in credit spreads better than the conventional principal component approach. The first strong factor is related to the contemporaneous state of the economy. The second strong factor represents investors ’ expectations about future economic conditions, and is shown to have predictive power for the state of the economy over a two-quarter horizon. The weak factor is mainly related to the error-correction processes in short-term spreads