Monetary Policy and the Corporate Bond Market: Reaching for Yield or Information Effects?

Abstract

Does expansionary monetary policy induce investors to reach for yield and drive up the price of risky assets? Or, do investors interpret monetary policy easing as a signal that economic fundamentals are weaker than they previously believed, prompting riskier asset prices to fall? We test these two competing hypotheses — i.e., the “reaching for yield” hypothesis and the “Fed information effect” hypothesis — in the context of the U.S. corporate bond market and find evidence strongly in favor of the latter. Following an unanticipated easing (tightening) of monetary policy on Federal Open Markets Committee announcement days, returns on corporate bonds with higher credit risk underperform (outperform) relative to safer corporate bonds. We conclude that monetary policy surprises are predominantly interpreted by market participants as signaling information about the state of the economy.