Spurious cross-sectional dependence in credit spread changes

In order to understand the lingering credit risk puzzle and the apparent segmentation of the stock market from credit markets, we need to be able to assess the strength of the cross-sectional dependence in credit spreads. This turns out to be a non-trivial task due to the extreme data sparsity that is typical for any panel of credit spreads that is extracted from corporate bond transactions. The problem of data sparsity has led to some erroneous conclusions in the literature, including inferences that have been drawn from spurious cross-sectional dependence in credit spread changes. Understanding the pitfalls leads to improved estimation of the latent factor in credit spread changes and its characteristics. (C) 2019 EcoSta Econometrics and Statistics. Published by Elsevier B.V. All rights reserved.