1 A Multifactor Model of Credit Spreads

We represent credit spreads across ratings as a function of common unobservable factors of the mean-reverting normal (Vasicek) form. Using a state-space approach we estimate the factors, their process pa-rameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of struc-tural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also con-tribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a system-atic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to mac-roeconomic variables. This suggests that liquidity risk is largely driven by the same factors as default risk