Credit Risk and Market Risk : Analyzing U.S. Credit Spreads

We disentangle U.S. credit spreads' evolution into two distinct parts resulting from market risk and default risk influences. We consider credit spreads (versus Treasury yields) as a credit risk proxy and S&P500 stock index as a market/systematic risk proxy. Such data allow for achieving a sensitivity study of credit risk to systematic risk along with industry, credit rating and maturity risk levels. First, we extract the common unobserved component of credit risk (i.e., common latent factor) from observed credit spread data in the light of the three previous risk dimensions. We exhibit then the sensitivity of credit risk to market risk according to those three risk levels. Second, we investigate the link prevailing between the common latent factor and S&P500 stock index along with those three risk dimensions. We exhibit therefore the link prevailing between the systematic component of credit spreads (i.e., credit risk) and S&P500 index as a proxy of market risk factor. We find that employing S&P500 stock index as a proxy of the systematic risk component in U.S. credit spreads generates a valuation bias while assessing credit risk