A reduced form model of default spreads with Markov-switching macroeconomic factors

We examine the ability of observed macroeconomic factors and the possibility of changes in regime to explain the proportion of yield spreads caused by the risk of default in the context of a reduced form model. For this purpose, we extend the Markov-switching risk-free term structure model of Bansal and Zhou (2002) to the corporate bond setting and develop recursive formulas for default probabilities, risk-free and risky zero-coupon bond yields as well as credit default swap premia. The model is calibrated with consumption, inflation, risk-free yields and default data for Aa, A and Baa bonds from the 1987 to 2008 period. We find that our macroeconomic factors are linked with two out of three sharp increases in the spreads during this sample period, indicating that the spread variations can be related to macroeconomic undiversifiable risk. (C) 2011 Elsevier B.V. All rights reserved.