RT Journal Article SR Electronic T1 Another Look at the Relation Between Credit Spreads and Interest Rates JF The Journal of Fixed Income FD Institutional Investor Journals SP 59 OP 71 DO 10.3905/jfi.2007.688966 VO 17 IS 1 A1 Mingyan Lin A1 Jean-Christophe Curtillet YR 2007 UL https://pm-research.com/content/17/1/59.abstract AB Empirical research until now has mostly documented a negative relation between movements in interest rates and credit spreads. This negative relation is counterintuitive. But since it exists as a matter of fact, it has been widely utilized in testing theoretical models of default risk. Those models compatible with this negative relation, such as Merton's model, are in turn recognized as the explanation for this originally surprising empirical result. In this article we suggest a way to break down AA bank credit spreads into 3 risk components: default risk, downgrade risk, and liquidity risk. Further analysis indicates that the liquidity risk layer is responsible for the negative correlation, while the default risk layer has a slightly positive correlation with interest rates. This result implies that using the whole credit spread in empirical studies to test default risk models may generally lead to incorrect conclusions. In addition, we provide a simple econometric model using on US market data for the liquidity risk layer which shows a more intuitive explanation of the apparent negative correlation. Finally, we also discuss the long-term behavior of interest rates and credit spreads, and suggest that there is no clear long-term relationship.TOPICS: Fixed income and structured finance, credit risk management, statistical methods