Why do bank stock returns increase from increased credit risk?

Question

As part of my bachelor's thesis, I am running the following regression on daily bank excess returns:

(r-rf)=Beta * Market excess return + Beta * Level(5Y)+ Beta * Credit Risk + error

Level(5Y) is the daily return on a portfolio of 5-year maturity treasury bonds and captures interest rate risk. Credit risk is obtained by taking the residual of the daily returns of a portfolio of BBB bonds when regressing them on the interest rate factor, so they are orthogonal.

While all other betas turn out reasonable, the credit risk beta is -0.59 (significant) in 2016-2019 and I do not understand how it can be so negative. BBB bonds yield positive returns when yields decrease, which means decreased credit risk - and my results show that bank returns decrease following this. Shouldn't this be good for bank equity returns? I was thinking if they may be using credit derivatives but found that this has decreased a lot since 2008. Does anyone have an explanation to this credit risk result? It would be so greatly appreciated.

Answer 1

Your “Credit Risk” variable sounds like it should be more accurately described as “Credit Spread”, which proxies the risk of loans. As credit spreads increase, the risk of the loans a finance company’s portfolio increases. Since finance company portfolios are becoming more risky, investors require higher compensation for that risk, which lowers the price. So as credit spreads go up, financial firms realize negative returns, all else equal. Hence, you get a negative coefficient on your credit spread factor.