European Corporate Bond Research Articles

Common Factors in the Performance of European Corporate Bonds – Evidence Before and after Financial Crisis

This paper examines common risk factors in Euro-denominated corporate bond returns before and after recent financial crisis. Our results suggest that level and slope of interest rate and default spread term structures significantly improve the explanatory power of asset pricing models for the cross-section of corporate bonds. Further, we demonstrate that corporate bonds with maturities between one and three years continue to yield statistically significant abnormal returns even after controlling for the levels and slopes of interest and default spread term structures. The abnormal returns are up to 151 basis points annually for these short term bonds and are thus of considerable economic interest. The sensitivity of corporate bond returns to interest rate level and slope risk is quite stable over time, whereas the sensitivity to level and slope default risk factors changed during the period of recent financial crisis. Our results are robust to GRS-test, calendar seasonality, and use of alternative risk-free benchmarks.

European Asset Swap Spreads and the Credit Crisis

We examine time-varying behavior and determinants of asset swap (ASW) spreads for 23 iBoxx European corporate bond indexes stratified by industry, credit rating and seniority. The results of a Markov switching model suggest that ASW spreads exhibit regime dependent behavior. The evidence is particularly strong for Financial and Corporates Subordinated indexes. Stock market volatility determines ASW spread changes in turbulent periods whereas stock returns tend to affect spread changes in periods of lower volatility. Whilst market liquidity affects spreads only in turbulent regimes the level of interest rates is an important determinant of spread changes in both regimes. Finally, we identify stock returns, lagged ASW spread levels, and lagged volatility of ASW spreads as major drivers of the regime shifts.

Interest rate sensitivity of the European stock markets before and after the euro introduction

Introduction of the euro altered corporate financing markets for the euro zone firms in an unprecedented way. Since 1999, firms from the euro zone countries are able to raise funds in their home currency in the large common currency market. I find that while stock returns in most countries in the Western Europe were negatively correlated with interest rate changes prior to the euro, that correlation has disappeared since 1999. My results reveal that recent growth in European corporate bond markets has played an important role in enabling firms to better manage their interest rate risk.

Liquidity Risk Premia: An Empirical Analysis of European Corporate Bond Yields

In this study we highlight the importance of liquidity risk, especially in periods of market stress, and advocate in favour of an explicit consideration of a liquidity premium when using mark-to-model methodologies to value financial assets.For European corporate bonds, we show that the liquidity premium, calculated as the difference between the yield spread of corporate bonds and the spread of credit default swaps, grew significantly during the recent market turmoil not only in absolute terms but also in relative terms. Although liquidity premiums were far from stable during the time frame of analysis – from 1 January 2005 to 31 December 2009 – on average roughly 40% of corporate yield spreads can be interpreted in terms of liquidity premia.We propose direct matching between the CDS and the underlying reference assets when computing liquidity premia. This differs from what seems to be the industry standard, which is simply to use indices when trying to infer market implied liquidity premia. Although computationally more demanding, the method we use is sounder from a theoretical point of view and produces richer results and analysis. With this method we are able present an analysis of liquidity risk premia per sector of activity.

Factor Decomposition and Diversification in European Corporate Bond Markets

In this paper we present an analysis of diversification strategies on portfolios of European corporate bonds. From the perspective of a U.S.-based investor we study whether mean-variance diversification strategies change as a result of the introduction of the European Economic and Monetary Union (EMU). Using a comprehensive and unique data set of European corporate bonds we show that country factors are more important than industry factors to describe the cross-section of European corporate bonds. In particular we find that in the Post-EMU period country factors remain important.

Are European Corporate Bond Markets Integrated? A Macro-Finance Term Structure Model Approach

This paper proposes a term structure model of risk-free yields and corporate credit spreads for the European bond market. In addition to latent factors, we include observable macro factors that are linked to inflation, real activity, and financial activity. Following the approach of Ang and Piazzesi (2003), we model the term structure simultaneously by using yield and macroeconomic data on the Euro zone for the January 2000-September 2008 period. Empirical evidence suggests that the European bond market is integrated to a significant degree. However, it has not yet reached the level of the U.S. bond market due to some residual segmentation and market frictions.

The Cost of Barriers to Entry: Evidence from the Market for Corporate Euro Bond Underwriting

The advent of the euro has eroded many of the barriers that segmented the European corporate bond market along currency lines and given rise to a unified market comparable in size to the one denominated in US dollars. In doing so, the new currency has made it easier for investment banks to explore scale economies in the provision of underwriting services, lowered the entry barriers to this industry, and made it easier for European borrowers to benefit from scope economies by combining their purchasing of commercial and investment banking services. This paper shows that the arrival of the euro led to a reduction in the underwriting fees of corporate bonds issued in the new currency and that this reduction was largely due to greater contestability of the investment banking business in the post-EMU European market. Our paper also shows that the elimination of market segmentation led to a migration of underwriting business towards the larger international investment banking houses, particularly those from the United States, rather than an intensification of the business links between euro area borrowers and bankers from the same country. Moreover, borrowers that chose American investment banks appear to have made extra savings in the underwriting fees. Finally, our analysis shows that these fee savings were not overcome by an increase in the credit spreads of these borrowers' bonds at issue date. Altogether, these results suggest that borrowers attach more weight to placing capacity than to business relationships in the choice of an underwriter.

Implications for Liquidity from Innovation and Transparency in the European Corporate Bond Market

This paper offers a new framework for the assessment of financial market liquidity and identifies two types: search liquidity and systemic liquidity. Search liquidity, i.e. liquidity in “normal” times, is driven by search costs required for a trader to find a willing buyer for an asset he/she is trying to sell or vice versa. Search liquidity is asset specific. Systemic liquidity, i.e. liquidity in “stressed” times, is driven by the homogeneity of investors - the degree to which one’s decision to sell is related to the decision to sell made by other market players at the same time. Systemic liquidity is specific to market participants’ behaviour. This framework proves fairly powerful in identifying the role of credit derivatives and transparency for liquidity of corporate bond markets. We have applied it to the illiquid segments of the European credit market and found that credit derivatives are likely to improve search liquidity as well as systemic liquidity. However, it is possible that in their popular use today, credit derivatives reinforce a concentration of positions that can worsen systemic liquidity. We also found that post-trade transparency has surprisingly little bearing on liquidity in that where it improves liquidity it is merely acting as a proxy for pre-trade transparency or transparency of holdings. We conclude that if liquidity is the objective, pre-trade transparency, as well as some delayed transparency on net exposures and concentrations, is likely to be more supportive of both search and systemic liquidity than post-trade transparency. JEL Classification: G14, G15, G18.

Liquidity Risk Premia in Corporate Bond Markets

This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that corporate bond returns have signifcant exposures to fluctuations in treasury bond liquidity and equity market liquidity. Further, this liquidity risk is a priced factor for the expected returns on corporate bonds, and the associated liquidity risk premia help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.6% per annum for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1.5% per annum. We find very similar evidence for the liquidity risk exposure of corporate bonds for a sample of European corporate bond prices.

Are European Corporate Bond and Default Swap Markets Segmented?

Market prices of corporate bond spreads and of credit default swap (CDS) rates do not match each other. In this paper, we argue that the liquidity premium, the cheapest-to-deliver (CTD) option and actual market segmentation explain the pricing differences. Using the European transaction data from Reuters and Bloomberg, we estimate a liquidity premium that is time-varying and firm-specific. We show that when time-dependent liquidity premiums are considered, corporate bond spreads and CDS rates behave in a much closer way than previous studies have shown. We also find that high equity volatility drives pricing differences that can be explained by the CTD option.

Are European Corporate Bond and Default Swap Markets Segmented?

Market prices of corporate bond spreads and of credit default swap (CDS) rates do not match each other. In this paper, we argue that the liquidity premium, the cheapest-to-deliver (CTD) option and actual market segmentation explain the pricing differences. Using the European transaction data from Reuters and Bloomberg, we estimate a liquidity premium that is time-varying and firm-specific. We show that when time-dependent liquidity premiums are considered, corporate bond spreads and CDS rates behave in a much closer way than previous studies have shown. We also find that high equity volatility drives pricing differences that can be explained by the CTD option.

Assessing Bond Market Developments Pot‐Euro

As a result of global trends in the financial industry, European financial markets are in the midst of a major transformation, and Economic and Monetary Union (EMU) is acting as a primary catalyst for such change. Over time financial integration will provide European markets with sufficient liquidity and scale to turn them into effective rivals of the U.S. markets.This paper provides a framework for assessing the likely consequences of EMU for the evolution of European bond markets. First, it discusses broad fundamental shifts in international capital flows and how EMU is expected to affect them. Second, it analyzes in some detail the two most important portfolio shifts expected to accompany Monetary Union: potential changes in currency reserves held by central banks and diversification of international investors' portfolios. Third, it considers the possibility that the asset management industry and households' increased appetite for risk will lead to a major shift on the demand side. On the supply side, it explores the likely effect of Monetary Union on government bond yield spreads and expected changes in the key pricing factors.The paper concludes with an overview of the considerable growth prospects for the European corporate bond market. In the Euromarket, which has traditionally been the preserve of borrowers of high credit standing, there have already been signs of increased interest in corporate issues, particularly lower‐rated ones. The search for higher yields by investors, greater expertise in analyzing credit risks by institutional investors, and reduced issuance in European government bond markets will combine to spur growth in the European corporate bond market. As a consequence, the traditional bank‐oriented relations will clearly weaken, and more companies will find opportunities to raise capital and obtain financing at lower cost.

Determinants of Risk Premiums on Corporate Bonds

ECONOMISTS have long agreed that the rate of interest on a loan depends on the risks the lender incurs. But how lenders estimate these risks has been left largely to conjecture. This paper presents and tests a hypothesis about the determinants of risk premiums on corporate bonds. By risk premium is meant the difference between the market yield on a bond and the corresponding pure rate of interest. My hypothesis is as follows: (1) The average risk premium on a firm's bonds depends first on the risk that the firm will default on its bonds and second on their marketability. (2) The "risk of default" can be estimated by a function of three variables: the coefficient of variation of the firm's net income over the last