Credit Risk, Interest Rate Risk, and the Business Cycle

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Abstract
This study is an empirical analysis of the link between credit risk and interest rate risk and investigates the presence of a business cycle component in the determination of credit spreads. The results of a simple regression indicate that credit spreads are much more sensitive to interest rates and stock returns during recessions, an effect even more pronounced for lower rated bonds. In a vector autoregression setting, when the variance of credit spreads is decomposed it is found that most of the credit risk stems from changes in long-term risk–free interest rates. During recessions, business cycles and monetary policy variables play an important role as well. Furthermore, systematic risk seems to matter much more for credit spreads than for stocks.