Regime-Switching Dynamic Nelson-Siegel Modeling to Corporate Bond Yield Spreads with Time-Varying Transition Probabilities

Abstract

The purpose of this study is to develop a regime-switching extension of the dynamic Nelson-Siegel term structure model and apply it to Japanese corporate bond spread data on an individual firm basis for the period April 1997 through December 2011. The results indicate that the estimated regime probability is closely linked to business and market sentiment. The regime-switching model is extended by adopting a time-varying transition probability matrix driven by leading macroeconomic indicators. The overall fit is improved by incorporating a time-varying transition probability matrix. Our results imply the importance of incorporating regime shifts into modeling the term structure of credit spreads.