Correspondence to: Carolina Castagnetti, Dipartimento di Economia Politica e Metodi Quantitativi, Via San Felice 5, 27100 Pavia, Italy. E-mail:


This paper investigates the determinants of credit spread changes in euro-denominated bonds. We adopt a factor model framework, inspired by the credit risk structural approach, as credit spread changes can be easily viewed as an excess return on corporate bonds over Treasury bonds. We try to assess the relative importance of market and idiosyncratic factors as an explanation of movements in credit spreads. We adopt a heterogeneous panel with a multifactor error model and propose a two-step estimation procedure, which yields consistent estimates of unobserved factors. The analysis is carried out with a panel of monthly redemption yields on a set of corporate bonds for a time span of 3 years. Our results suggest that the euro corporate market is driven by observable and unobservable factors. The unobservable factors are identified through a consistent estimation of individual and common observable effects. The empirical results suggest that an unobserved common factor has a significant role in explaining the systematic changes in credit spreads. However, in contrast to evidence regarding US credit spread changes, it cannot be identified as a market factor. Copyright © 2011 John Wiley & Sons, Ltd.