Dependence of structural breaks in rating transition dynamics on economic and market variations

The financial crisis of 2007-2008 has caused severe economic and political consequences over the world. An interesting question from this crisis is whether or to what extent such sharp changes or structural breaks in the market can be explained by economic and market fundamentals. To address this issue, we consider a model that extracts the information of market structural breaks from firms’ credit rating records, and connects probabilities of market structural breaks to observed and latent economic variables. We also discuss the issue of selecting significant variables when the number of economic covariates is large. We then analyze market structural breaks that involve U.S. firms’ credit rating records and historical data of economic and market fundamentals from 1986 to 2015. We find that the probabilities of structural breaks are positively correlated with changes of S&P500 returns and volatilities and changes of inflation, and negatively correlated with changes of corporate bond yield. The significance of other variables depends on the inclusion of latent variables in the study or not.