A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium

Abstract

Using a Markov switching unobserved component model we decompose the term premium of the North American CDX investment grade index (CDX-IG) into a permanent and a stationary component. We explain the evolution of the two components in relating them to monetary policy and stock market variables. We establish that the inversion of the CDX index term premium is induced by sudden changes in the unobserved stationary component, which represents the evolution of the fundamentals underpinning the probability of default in the economy. We find strong evidence that the unprecedented monetary policy response from the Fed during the 2008-2009 financial crisis period was effective in reducing market uncertainty and helped to steepen the term structure of the index thereby mitigating systemic risk concerns. The impact of stock market volatility, as captured by the VIX index, in flattening the term premium was substantially more robust in the crisis period. We also show that equity returns make a substantial contribution to the term premium over the entire sample period.