Macro risk factors of credit default swap indices in a regime-switching framework

Using the Markov regime-switching model, this paper examines factor loadings on macroeconomic, market sentiment and other variables that may explain North American investment-grade and high-yield credit default swap indices (CDX) over the period 2003–2011. In both crisis and tranquil market states, spreads are positively related to the market-wide default premium and VIX, and negatively related to changes in Treasury bond yields, the underlying stock index returns and the Fama–French's High-Minus-Low factor. The magnitude of the factor loadings is higher during crisis periods. The results suggest the need to consider regime dependent hedge ratios to manage credit risk exposure.