Decomposing European CDS Returns

Nearly half of the variation in European CDS returns is captured by a novel factor that mimics economic catastrophe risk. During the financial crisis of 2007-8, this factor became more important relative to other sources of risk, leading to a shift in the correlation structure of CDS returns. Using equivalent CDS and equity portfolios, we show that while crucial for explaining temporal and cross-sectional variation in CDS returns, the factor plays a lesser role for equity. This is likely due to the limited sensitivity of the equity value at default to whether the event is of systemic or idiosyncratic nature.