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					 Predicting fixed income
credit spread movements
       March 1, 2001
         Mary Murphy
         Luisa Rubino
         Steve Smigie
         Gigi Widham
              Summary
 Prediction of direction and magnitude of
  credit spread movements for:
  • 10-year US Swap Spread
  • spread between US corporate AAA 7-10 year
    and 10-year Treasury Bond
  • spread between US corporate BBB 7-10 year
    and the 10-year Treasury Bond
 Prediction was most successful for the
  spread between AAA and 10-year T-Bond
 Trading strategy produces an annualized
  alpha of 1.01%
 Predictive power can be used to test
  other trading strategies
     Why Credit spreads?
 Increase in significance of corporate debt
  in fixed income portfolio management
 Decrease in supply of Treasury bonds
 Reduction in number of fixed income
  asset classes in Europe
 Relevance of credit risk for fixed income
  investors
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                                                                                                                                                                                                                                                                                Historical trend of monthly spreads




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                                                                                                                                                                                                                 Corporate spreads



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                                                                                                                                                                                                                                                                                                                      Historical trends




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                                                                                                                      Historical Trend of 10 year Swap Spreads




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                                                                                        Swap spreads




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         Methodology
 Reviewed existing research
 Focused on financial variables
 Used in-sample data from January
  1990 to December 1999
 Tested models out of sample from
  January 2000 to December 2000
                  Variables
   Lag of the change in S&P 500 P/E
   Lag of the S&P 500 P/E
   Lag of the change in the VIX
   Lag of the change 30-year Treasury Bond future
    volatility
   Lag of the change in the 10 year on/off spread
   Lag of the change in the yield of 10-year
    Treasury bonds
   Lag of the spread btwn BBB and the AAA yields
    (7-10yr maturities)
   Lag of the change in spread between the 10 year
    T-bond and 3 Month T-bill
   Lag of change of each credit spread
   Lag of each credit spread
                      Models
  AAA Spread t = 0.103 - 0.511 AAA Spread t-1 + 0.477
  Swap Spread t-1 - 0.039  S&P500 P/E t-1

  BBB Spread t = 0.111 – 0.148  AAA Spreadt-1 + 0.808
   Swap Spread t-1 + 0.273 10yr T-bond t-1 - 0.049 
  S&P500 P/E t-1 + 0.614  BBB - AAAt-1

  Swap Spread t = - 0.016 + 0.002 S&P500 PE t-1 - 0.055
  Swap Spread t-1 – 0.004  S&P500 P/E t-1 + 0.032  BBB
  Spread t-1
     Interpretation of models
                                AAA - 10yr Tb BBB - 10yr Tb   Swap Spread
Adjusted R^2                          0.32774       0.29193        0.06515
F-Statistic                          20.17536      10.72997        2.58430
Standard Error of Estimate            0.16218       0.18778        0.04747
Mean Absolute Error                   0.02630       0.03526        0.00225
Durbin Watson                         1.94935       2.21830        1.87324
In-Sample directional hit             67.23%        69.75%         52.94%
Out-of-Sample directional hit         58.33%        66.67%         58.33%
             Trading strategy
 Long position in BBB corporate
  bonds and short equal amount in 10
  year Treasury bond when model
  predicts that credit spreads tighten
 Results: (vs. benchmark of 30 day
  Euro$)
Hit Rate                                      69.47%
Total Return (for ten years)                  12.16%
Total Benchmark Return (for ten years)        1.43%
Total Return over Benchmark (for ten years)   10.73%
Annualized Return                             1.15%
Annualized Benchmark Return                   0.14%
Annualized return over Benchmark              1.01%
 Conclusions/future paths
         of study
 Credit spread movements are
  predictable
 Models include valuable information
  to predict business cycle
 Future research could test trading
  strategies that capitalize on the
  predictive power
Q&A

				
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