Bond Spreads Research Articles

Sovereign Credit Quality and Violations of the Law of One Price

Abstract It is well-documented that government bonds with almost identical cash flows can trade at different prices. This article analyzes the cross-section of bond spreads across developed European countries and documents a novel result. While a measure of the convenience yield of government bonds helps explain these spreads, it cannot explain the behavior of bond spreads in periods of widening credit risk. The article documents bond spreads between new and old issues tighten for low-quality sovereigns. In other words, the newer more liquid bonds become cheaper, not more expensive, relative to their older counterparts. We offer an explanation based on price pressure and provide empirical support using data on net flows of investors in sovereign bonds.

The Evolution of the Lead-lag Markets in the Price Discovery Process of the Sovereign Credit Risk: the Case of Italy

Abstract Hedging and speculative strategies play a key role in periods of financial market volatility particularly during economic crises. In such contexts, liquidity problems tend to evolve into potential credit risk events that amplifies the volatility of several markets such as the CDS and the government bond markets. The former, however, generally embodies a higher sensitivity to volatility due to the operators’ uncertainty about unstable and countercyclical counterparty risk. The aim of this paper is to analyze the long-lasting dynamic relationship between credit default swap (CDS) premia and government bond yield spreads (GBS), by focusing particularly on sovereign credit risk, in order to evaluate the lead-lag markets in the price discovery process against the backdrop of a deep financial crisis. The focus of this study concerns the country of Italy, one of the major European countries that suffers from both weak GDP growth and high public debt, which subjects it to volatility and speculation during periods of financial stress. JEL classification numbers: G01, G12, G14, G20. Keywords: CDS spreads, Government bond spreads, Credit risk, Cointegration, Vector error correction model, Granger-causality.

The Intra-Regional Spillover Effect of Bond Defaults: Evidence from China's Credit Bond Market

Taking the first bond defaults in each province in China as credit events, we adopt a difference-in-difference model and find that credit spreads of other corporate bonds in the same province increase by 6 basis points on the first default event day, suggesting a spillover effect. The spillover effect is stronger for local state-owned-enterprise bond defaults, and the magnitude of the spillover effect is negatively related to firm-government connections. Meanwhile, defaults related to investor protection clauses have the largest spillover effect. We also find that provinces with higher GDP growth rates and higher general public budget revenue are less affected by the first bond defaults. Overall, our paper provides new evidence of an intra-regional spillover effect in bond defaults.

Financial stress in lender countries and capital outflows from emerging market economies

We investigate if financial stress in countries where international banks are headquartered is a major driver of the withdrawal of these banks’ credit to emerging market economies (EMEs). We find that when financial stress, measured by sovereign or bank CDS spreads or corporate bond spreads, increases, international banks decrease their lending to EMEs, which acts as a major driver of capital outflows from EMEs. In particular, financial stress in lender countries is a more important driver than the local financial conditions and macroeconomic fundamentals of EMEs. Such results hold for both the countries that experienced crises and those that did not, during the Global Financial Crisis (GFC). Such results also generally hold even after the GFC period, but to a lesser extent. Our findings suggest that it is desirable for EME policymakers to promote diversification of lender countries.

Emerging Market Economy Exchange Rates and Local Currency Bond Markets Amid the COVID-19 Pandemic

Borrowing through domestic currency bonds has not insulated emerging market economies (EMEs) from the financial shock unleashed by Covid-19; EME local currency bond spreads spiked amid sharp currency depreciations and capital outflows.Portfolio investors face amplified losses as local currency spreads and exchange rates move in lockstep; their revised portfolio allocations in turn strengthen this correlation.EMEs with monetary policy frameworks that are equipped to address the feedback loop between exchange rate depreciation and capital outflows stand a better chance of weathering the financial fallout from the Covid-19 pandemic.To counter large stock adjustments in domestic bond markets, EME central banks may need to expand their toolkit to take on a "dealer of last resort" role; a number of them are already moving in this direction.

The Nonlinear Dynamics of Corporate Bond Spreads: Regime-Dependent Effects of their Determinants

Abstract This paper studies the behavior of corporate bond spreads during different market regimes between 2004 and 2016. Applying a Markov-switching vector autoregressive (MS-VAR) model, we document that the dynamic impact of spread determinants varies substantially with market conditions. In periods of high volatility, systematic credit risk—rather than interest rate movements—contributes to driving up spreads. Moreover, while market-wide liquidity risk is not priced when volatility is low, it becomes a crucial factor during stress periods. Our results challenge the notion that spreads predominantly capture credit risk and suggest it must be reassessed during periods of financial distress.

Equity Returns, Bond Spreads, and Economic Activity in Emerging Countries

While simultaneously accounting for the effects of sovereign and corporate bond spreads, we document that emerging market economy (EME) equity returns have a strong predictive power for future output growth and account for a significant fraction of output fluctuations in these countries. Our results are based on the environment of Caballero, Fernandez, and Park (2019), who show that corporate bond spreads are a better driver of EME economic activity than sovereign bond spreads. We find that equity returns, a proxy of domestic and external financial conditions, play a more important role for EME output growth than both types of bond spreads. We attribute this difference to the effectiveness of equity returns in transmitting global financial risk shocks to EMEs and to the role of equity issuance in international capital flows in EMEs.

Measuring and Pricing Cyclone-Related Physical Risk Under Changing Climate

We propose a statistical methodology to quantify the financial implications of tropical cyclone-related physical risks implied by climate change. To address the sensitivity of disaster intensity to climate change, we provide a Monte Carlo methodology to generate synthetic cyclones consistent with climate scenarios of the Couple Model Intercomparison Project (CMIP5). Sovereign exposure and vulnerability assessments in principal tropical cyclone basins are based on projections of population densities in shared socioeconomic pathways coupled with downscaled physical asset values constructed using mixed data along with locally calibrated damage functions. Finally, we compute the direct climate impact on emerging countries’ bond spreads using the spread sensitivity to the debt to GDP ratio, assuming that damage costs are financed by issuing new government debt. We find that the ‘business as usual’ RCP8.5 concentration scenario coupled with the ‘middle road’ shared socioeconomic pathway (SSP2) leads to global average annual damages 142% larger than in the concentration scenario RCP2.6 allowing to remain under 2°C warming. In terms of emerging market impact, we estimate that in 2070-2100, the impact of extreme cyclones on the bond spread of most vulnerable countries will up to 200 bps higher in the RCP8.5 pathway than in the 2°C baseline. In every step of our assessment, we quantify the impact of model uncertainty on our results using 7 different climate models from the CMIP5 database.

Sovereign Risk and Financial Risk

This paper examines the relationship between sovereign bond spreads, local economic activity, and global financial risk. We use secondary-market prices of dollar-denominated sovereign securities to construct yield spreads between sovereign bond yields and yields on the appropriately defined default risk-free securities, constructed using zero-coupon U.S. Treasury yields. We use these spreads to construct country-specific sovereign bond spreads for a sample of almost 50 countries over the 1980-2012 period. We then examine the extent to which movements in sovereign spreads are determined by local risk factors, such as fluctuations in exchange rates and local stock market returns, versus global risk factors that arguably proxy for risk-attitudes that prevail in U.S. financial markets. To measure global risk factors we rely on the excess bond premium constructed by Gilchrist and Zakrajsek (2012). The excess bond premium is a measure of distress in U.S. corporate bond markets and comoves closely with conditions in financial markets. According to GZ, the excess bond premium provides a quantitative measure of the risk-attitudes of financial intermediaries. Our results indicate that a substantial portion of the comovement among sovereign spreads can be accounted for by changes in such global risk factors. We also examine the extent to which, during the 2007-09 financial crisis, such global risk factors were related to perceived default risk in the U.S. financial sector. Next, we extend our methodology to construct credit spreads for euro-denominated sovereign bonds for about 40 countries over the 2000-2012 period, and we examine the implications of our empirical pricing framework for comovement among sovereign spreads during the ongoing turmoil in European sovereign debt markets. Lastly, we study the e§ect of various stabilization policy announcements during the recent financial crisis on sovereign bond spreads through the global risk factors. We also compare the impacts of stabilization policy measures during financial crises in the past. Lastly, we construct a general equilibrium model of sovereign debt and default to rationalize the empirical findings. The model features include a risk-averse global investor, optimal default, and endogenous debt dynamics for multiple countries. The sovereign default and bond prices depend on the borrower's economic conditions as well as the lender's risk aversion and riskiness. We quantitatively examine the link between the financial risk that the lender faces and the distribution of sovereign risk.

Explain the Determinants of Credit Spreads in the US

This paper focuses on how economic variables affect Baa corporate bond spreads in the US from January 1990 to December 2018. Credit spreads in this paper are defined as the Baa corporate bond yield minus the Aaa corporate bond yield, and are explained by four variables which are interest rates, the slope of yield curve, the stock market volatility and the economic environment. Cointegration analysis and VAR model are used in this paper to estimate the effects of the determinants of the credit spreads in the long-run and in the short-run respectively. The impacts of the industrial production index and the slope of yield curve on the Baa credit spread are negative, and the impacts of 10 year Treasury bond rate and the stock market volatility on the credit spreads are positive in the long run. In the short-run dynamic relationship, the impact of the industrial production index and the 10 years Treasury bond interest rate are negative for the credit spreads, and the slope of yield curve and stock market volatility are positive for the Baa credit spreads.

The Factors Affecting Corporate Bond Spreads

The Factors Affecting Corporate Bond Spreads

The CSPP impact on non-financial firms’ cost of borrowing and debt choice

In this study, we examine the impact of the European Central Bank’s (ECB) corporate sector purchase programme (CSPP) on euro area non-financial firms’ cost of borrowing and choice between bank and public debt. Using a large sample of corporate bonds and syndicated loans closed between 2000 and 2019, we find that the CSPP reduced corporate bond spreads significantly, in both announcement and implementation periods. Findings also suggest that the CSPP had a positive spillover effect into the syndicated loan market during the implementation period. Our results show that there is a substitution effect between eligible bonds and equivalent loans, with non-financial firms choosing to use more corporate bonds than syndicated loan deals after the CSPP announcement, and that this effect is more important for non-switchers, those that may have more difficulty in accessing the bond market. Finally, we provide evidence that, when controlling for the CSPP, borrowers that choose corporate bonds are larger, more profitable, and have larger growth opportunity sets; and switchers with high agency costs of debt prefer bank debt.

Do Risk Premia Explain Dealer Markups in Municipal Bond Offerings?

Underpricing of municipal bond offerings in the primary market raise borrowing costs for state and local borrowers. We argue that a significant part of the primary market underpricing can be explained as compensation to dealers for their bearing of the price risk of newly-issued bonds. We demonstrate this by showing empirically that underpricing is increasing in the volatility of the market for United States Treasury bonds, in municipal bond market spreads, in municipal bond spread volatility, and in the duration of the newly-issued bonds.

Bank Shocks and the Debt Structure

This paper identifies shocks to bank credit supply based on firms’ aggregate debt composition. I use a model where firms fund production with bonds and loans. Only bank shocks imply opposite movements in the two types of debt as firms adjust their debt composition to new credit conditions. I use this result to inform a sign-restriction VAR and identify the sources of US business cycles. Bank shocks account for a third of output fluctuations and are predictive of the bond spread.

Dispelling the Shadow of Fiscal Dominance? Fiscal and Monetary Announcement Effects for Euro Area Sovereign Spreads in the Corona Pandemic

We use event study regressions to compare the impact of monetary versus fiscal policy announcements on government bond spreads of ten euro member countries. Our motivation is to evaluate which of the two players – the ECB or the fiscal level – has been more crucial for the stabilization of euro sovereign bond markets in the crisis environment of the pandemic. This question is of substantial relevance to assess potential risks for the effective independence of the ECB in the future. Our key result is that the pandemic monetary emergency measures through the PEPP have been highly effective, whereas fiscal rescue announcements had much less impact. We document a smaller and statistically significant spread-reducing effect only for the announcement of the Next Generation EU program. In contrast, a temporary relaxation of European fiscal rules through the activation of the emergency-escape clause under the Stability and Growth Pact is associated with rising spreads. Our results have an unpleasant implication for the debate on a looming fiscal dominance of the ECB in the presence of rising public debt levels as so far, the stabilization of sovereign bond markets appears to hinge largely on the Eurosystem's role as a massive buyer of high-debt countries' sovereign bonds.

A study on the relationship between the term structure of Japanese corporate bond spreads and the macro economy

Dr Takeshi Kobayashi, Professor of Business School of Nagoya University of Commerce and Business, is carrying out research which explores credit spreads and macroeconomic variables through a range of methodologies. He is hoping to gain new perspecitves and knowledge in this area by bridging the gap between finance and academia through detailed empirical analyses of corporate bond spreads and the relationship to macroeconomic variables.

Bond Risk Premia and The Exchange Rate

AbstractIn emerging market economies, currency appreciation goes hand in hand with compressed sovereign bond spreads, even for local currency sovereign bonds. This yield compression comes from a reduction in the credit risk premium. Crucially, the relevant exchange rate involved in yield compression is the bilateral U.S. dollar exchange rate, not the trade‐weighted exchange rate. Our findings highlight endogenous co‐movement of bond risk premia and exchange rates through the portfolio choice of global investors who evaluate returns in dollar terms.

Earnings management uncertainty, implicit guarantees, and the corporate bond yield spread: Evidence from China

We examine the impact of earnings management uncertainty (EMU) on bond yield spreads in China. In the process, we decompose the bond yield spread into liquidity and default yield spreads. The findings suggest that EMU primarily drives the default yield spread of a corporate bond and that its impact on the liquidity yield spread is minimal. Our results are robust to alternative metrics of default and liquidity yield spreads and to a battery of robustness checks. In addition, we find that the implicit government guarantees from both the Chinese central and local governments partially offset the impact of EMU on overall bond yield and default yield spreads.

Macro-Factors of Credit Spreads in Corporate Bonds

This study emphasizes on analysis of the macro factors of the credit spreads (CS) of the fixed-rate corporate bonds of non-financial enterprises.Firstly, industry growth (IG) has a significant negative impact on CSs. IG reflects the prosperity of the real economy. The increase of investment demand promotes the rise of bond prices and narrows the CSs; Secondly, consumer price index (CPI) has a significant positive impact on CS. On the one hand, the increase of inflation will reduce bond investment demand, on the other hand, it will increase investors' expectations of future tightening monetary policy. Uncertainty increases while default risk rises and CS widen. Thirdly, spreads of treasuries have a significant negative impact on CS. When the slope of the treasury yield curve increases and the expectation of interest rate increases, macro-economy is in an upward stage, and CS narrow. Fourthly, the analysis of VAR, variance decomposition and impulse response function show that the impact of CPI, IG and interest rate difference of national debt on spreads has time lag. While money supply affects CS by affecting CPI. This study discusses the CS which is very important for the asset allocations of investors. The investors and market participants should consider the macro-factors while invest in corporate bonds.

Green bonds: shades of green and brown

We analyse the existence of a green bond premium and find a negative premium of 8 to 14 basis points. We are further interested in the influence of ESG ratings on green bonds to determine if investors differentiate between the shade of green. Examining a unique dataset of green bonds, we find a statistically significant influence of ESG ratings on bond spreads. A one-point increase in the weighted average ESG score leads to a decrease in the spread of 6 to 13 basis points. Interestingly, the results are not driven by the environmental friendliness of the green bond issuer, but through the company’s governance.