The Journal of Financial Research • Vol. XXIX, No. 3 • Pages 421–439 • Fall 2006

CREDIT SPREADS AND THE ZERO-COUPON TREASURY SPOT CURVE

Nicolas Papageorgiou
HEC Montreal

Frank S. Skinner
University of Surrey

Abstract
We examine the relation between credit spreads on industrial bonds and the underlying Treasury term structure. We use zero-coupon spot rates to eliminate the coupon bias and to allow for a consistent study both within and across the different credit ratings. Our results indicate that the level and slope of the Treasury term structure are negatively correlated with changes in the credit spread on investment-grade corporate bonds. We also find that the relation between credit spreads and the Treasury term structure is relatively stable through time. This is good news for value-at-risk calculations, as this suggests that the correlations among assets of different credit classes are stable; therefore use of historic correlations to model spread relations can be valid. JEL Classification: G21, G24

I. Introduction In January 1996, the Basle committee on Banking Supervision adopted new capital requirements to cover the market risk exposure resulting from the daily trading activities of banks. The most important implication of these new capital requirements was that banks could now employ internal risk measurement models to calculate their minimum regulatory capital requirements. In contrast to market risk, models for other types of risk exposures were considerably less advanced and capital requirements for these risks remained subject to the existing regulatory framework instituted by the 1988 Basel Accord. Over the last few years, however, financial institutions have made large strides in developing statistical models to measure these other sources of risk, most notably credit risk. The Banking Committee is revising
We would like to thank Chris Brooks, Apostolos Katsaris, and Arthur Warga for valuable comments, as well as participants of