Credit Spread Changes and Equity Volatility: Evidence from Daily Data

We investigate the determinants of daily changes in credit spreads in the U.S. corporate bond market. Using a sample of liquid investment grade and high‐yield bonds, we show that both systematic bond and stock market factors as well as idiosyncratic equity market factors affect changes in the yield spread at the daily frequency. In particular, we find that increase in stock market volatility has a positive effect on changes in the spread of corporate bonds over the corresponding Treasuries beyond that captured by standard term structure variables. Our results show that there is an almost contemporaneous inverse relationship between changes in the bond yield spread and the stock return of the issuing firm.     

THE SLOPE OF THE TERM STRUCTURE OF CREDIT SPREADS: AN EMPIRICAL INVESTIGATION

In this article we analyze the slope of the term structure of credit spreads. We investigate the explanatory role of interest rate, market, and idiosyncratic equity variables that the recent empirical literature highlights as important determinants of credit spread levels. This study extends the analysis and assesses its effect on credit slopes for a sample of corporate bonds. We find that these factors affect credit spreads at short and long maturities in a significantly different way. A closer inspection of the credit spread slope also reveals that it is a useful indicator of the direction of changes in future short‐term credit spreads. This evidence has important implications for the trading and risk management of portfolios of bonds with different maturities.     

Accounting data and the credit spread: An empirical investigation

Measures of credit risk based on Merton (1974) rely upon information available in the market prices of securities. Under the Efficient Market Hypothesis market prices should reflect all available information and, hence, make redundant all other information in the analysis of credit risk. This paper examines whether accounting data are fully reflected in the market-based measures of credit risk and therefore has no role in explaining variations in the credit spread on corporate bonds. We use a sample consisting of over 11,000 firm-quarter observations with matched equity, bond and accounting data. The results suggest that equity volatility and Merton's distance-to-default outperform accounting variables in explaining variations in the credit spread. However, accounting variables are incrementally informative in explaining variations in the credit spread when considered in conjunction with market-based measures. Within the set of accounting variables considered, we find that the profitability ratio is by far the most incrementally informative accounting variable.     

A Multifactor Model of Credit Spreads

We represent credit spreads across ratings as a function of common unobservable factors of the Vasicek form. Using a state-space approach we estimate the factors, their process parameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of structural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also contribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a systematic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to macroeconomic variables. This suggests that if credit spread levels do contain a large liquidity premium, the time variation of this premium is likely driven by the same factors as default risk.     

The cross-section of expected corporate bond returns: Betas or characteristics?

This paper finds that default betas are significantly related to the cross-section of average bond returns even after controlling for characteristics such as duration, ratings, and yield-to-maturity. Among characteristics, only yield-to-maturity is significantly related to average bond returns after controlling for default and term betas. The default and term factors are able to price the returns of beta-sorted portfolios better than they do the returns of yield-sorted portfolios. The magnitude of the ex ante Sharpe ratio generated by yield-sorted portfolios suggests non-risk-based explanations. Overall, given the elusive nature of systematic risk in empirical asset pricing, the central finding of our paper is that systematic risk matters for corporate bonds.     

The Gilt-Equity Yield Ratio and the Predictability of UK and US Equity Returns

A number of financial variables have been shown to be effective in explaining the time-series of aggregate equity returns in both the UK and the US. These include, inter alia , the equity dividend yield, the spread between the yields on long and short government bonds, and the lagged equity return. Recently, however, the ratio between the long government bond yield and the equity dividend yield – the gilt-equity yield ratio – has emerged as a variable that has considerable explanatory power for UK equity returns. This paper compares the predictive ability of the gilt-equity yield ratio with these other variables for UK and US equity returns, providing evidence on both in-sample and out-of-sample performance. For UK monthly returns, it is shown that while the dividend yield has substantial in-sample explanatory power, this is not matched by out-of sample forecast accuracy. The gilt-equity yield ratio, in contrast, performs well both in-sample and out-of-sample. Although the predictability of US monthly equity returns is much lower than for the UK, a similar result emerges, with the gilt-equity yield ratio dominating the other variables in terms of both in-sample explanatory power and out-of-sample forecast performance. The gilt-equity yield ratio is also shown to have substantial predictive ability for long horizon returns.     

Determinants of yield spread dynamics: Euro versus US dollar corporate bonds

This paper presents a systematic comparison between the determinants of euro and US dollar yield spread dynamics. The results show that US dollar yield spreads are significantly more affected by changes in the level and the slope of the default-free term structure and the stock market return and volatility. Surprisingly, euro yield spreads are strongly affected by the US (and not the euro) level and slope. This confirms the dominance of US interest rates in the corporate bond markets. Interestingly, I find that liquidity risk is higher for US dollar corporate bonds than euro corporate bonds. For both regions, the effect of changes in the bid-ask spread is mainly significant during periods of high liquidity risk. Finally, the results indicate that the credit cycle as measured by the region-specific default probability significantly increases US yield spreads. This is not the case for euro yield spreads.     

The Gilt-Equity Yield Ratio and the Predictability of UK and US Equity Returns

A number of financial variables have been shown to be effective in explaining the time-series of aggregate equity returns in both the UK and the US. These include, inter alia , the equity dividend yield, the spread between the yields on long and short government bonds, and the lagged equity return. Recently, however, the ratio between the long government bond yield and the equity dividend yield – the gilt-equity yield ratio – has emerged as a variable that has considerable explanatory power for UK equity returns. This paper compares the predictive ability of the gilt-equity yield ratio with these other variables for UK and US equity returns, providing evidence on both in-sample and out-of-sample performance. For UK monthly returns, it is shown that while the dividend yield has substantial in-sample explanatory power, this is not matched by out-of sample forecast accuracy. The gilt-equity yield ratio, in contrast, performs well both in-sample and out-of-sample. Although the predictability of US monthly equity returns is much lower than for the UK, a similar result emerges, with the gilt-equity yield ratio dominating the other variables in terms of both in-sample explanatory power and out-of-sample forecast performance. The gilt-equity yield ratio is also shown to have substantial predictive ability for long horizon returns.     

Over‐the‐Counter Market Frictions and Yield Spread Changes

We empirically study whether systematic over‐the‐counter (OTC) market frictions drive the large unexplained common factor in yield spread changes. Using transaction data on U.S. corporate bonds, we find that marketwide inventory, search, and bargaining frictions explain 23.4% of the variation in the common component. Systematic OTC frictions thus substantially improve the explanatory power of yield spread changes and account for one‐third of their total explained variation. Search and bargaining frictions combined explain more in the common dynamics of yield spread changes than inventory frictions. Our findings support the implications of leading theories of intermediation frictions in OTC markets.     

CORPORATE BONDS AND PRODUCT MARKET COMPETITION

I examine the effect of product market competition on the yield spread of corporate bonds. I find that firms that face more competitive threats also face a higher cost of corporate bond debt. After controlling for common bond-level, firm-level, and macroeconomic variables, my results show that bondholders of firms that are subject to increased competition demand significantly higher credit spreads than holders of otherwise similar bonds. Furthermore, this effect is more pronounced for firms that have assets that are difficult to redeploy. Overall, my findings provide evidence that competitive threats are being reflected in corporate debt prices.     

Momentum spillover from stocks to corporate bonds

We investigate and improve momentum spillover from stocks to corporate bonds, i.e. the phenomenon that past winners in the equity market are future winners in the corporate bond market. We find that a momentum spillover strategy exhibits strong structural and time-varying default risk exposures that cause a drag on the profitability of the strategy and lead to large drawdowns if the market cycle turns from a bear to a bull market. By ranking companies on their firm-specific equity return, instead of their total equity return, the default risk exposures halve, the Sharpe ratio doubles and the drawdowns are substantially reduced.     

The relative and incremental explanatory powers of dirty surplus items for debt interest rate

This study investigates the relationship between dirty surplus items on the balance sheet and the cost of debt for Japanese firms. We focus on three dirty surplus items—unrealized gains and losses on available-for-sale securities (SEC), foreign currency translation adjustment (FOC), and land revaluation surplus (LAND). While many previous studies on dirty surplus adopted the value-relevance perspective, we examine the effect of dirty surplus items on the interest rate spread of bonds from the bond market perspective. We use the [Vuong, Q. H. (1989). Likelihood ratio tests for model selection and non-nested hypotheses. Econometrica, 57, 307–333] test to evaluate the relative explanatory power of the equity ratio with and without dirty surplus items for the interest rate spread on bonds issued. We find evidence that the equity ratio with dirty surplus items is more strongly associated with the debt interest rate than that without dirty surplus items. The results suggest that the total amount of dirty surplus items have statistically significant explanatory power for the interest rate spread. However, some dirty surplus items do not have explanatory powers for the bond interest rate spread. While FOC has relative and incremental explanatory powers and SEC has only incremental explanatory power, LAND has neither relative nor incremental explanatory power for the bond interest rate spread. The results mean that FOC and SEC are useful to Japanese bond investors.     

中国股债市场长期动态相关性的影响因素研究——基于宏观不确定性和协动性视角

本文借鉴现代宏观经济学中的无套利仿射模型,基于"定价核"的定价方式,将股票市场和债券市场收益率之间的相关系数分解为其主要驱动因素--通货膨胀、真实利率和股息率的不确定性,以及三者之间的协方差。在实证部分,采用DCC-MGARCH模型计算股票市场和债券市场收益率的动态相关系数,验证中国股债相关性的时变规则;进而通过回归分析探究所选取的解释变量对中国股债相关性的贡献。结果表明,通货膨胀和股息率的不确定性以及真实利率与通货膨胀和股息率各自之间的协动性是影响这种相关性的主要因素;通胀冲击、真实利率和股息率可以解释这种相关性与长期动态的暂时背离。其中,通货膨胀和股息率的不确定性对股债相关性的影响与其他欧美主要经济体有着不同的表现,反映了中国市场的特殊性;此外,相较于中国经济市场的平稳时期,股市动荡期间各经济因素的影响会发生改变,且模型解释力会降低。     

Conditional conservatism and the yield spread of corporate bond issues

Building upon recent research which indicates that debt markets rather than equity markets shape financial reporting, this study examines how conditionally conservative financial reporting relates to the yield spread of corporate bond issues. Our findings suggest that the debt contract efficiency/information costs view of conditional conservatism, documented in private debt contracts, does not generalize to public debt contracts. Instead, a debt contract renegotiation costs perspective seems to better capture the dynamics of the public debt markets, with conditionally conservative reporting being associated with higher yield spread of corporate bond issues. Additional subsample test results indicate that the association between conditional conservatism and bond yield spreads is more pronounced in non-investment grade bonds, for bond issuers with more financial distress, and for bonds that are issued before the passage of the Sarbanes–Oxley Act. This study fills a gap in the conservatism literature, which focuses primarily on equity or private bank loan markets with traditional debt contract efficiency/information costs view.     

The Impact of Macroeconomic and Financial Variables on Market Risk: Evidence from International Equity Returns

Using a GARCH approach, we estimate a time–varying two–factor international asset pricing model for the weekly equity index returns of 16 OECD countries. We find significant time–variation in the exposure (beta) of country equity index returns to the world market index and in the risk–adjusted excess returns (alpha). We then explain these world market betas and alphas using a number of country–specific macroeconomic and financial variables with a panel approach. We find that several variables including imports, exports, inflation, market capitalisation, dividend yields and price–to–book ratios significantly affect a country's exposure to world market risk. Similar conclusions are obtained by using lagged explanatory variables, and thus these variables may be useful as predictors of world market risks. Several variables also significantly impact the risk–adjusted excess returns over this time period. Our results are robust to a number of alternative specifications. We further discuss some economic hypotheses that may explain these relationships.     

Changes in volatility of credit spread and market efficiency during rapid growth of credit-related securities

This paper investigates the changes in credit spread volatility during 1993–2001. We find that the credit spreads between junk-grade corporate bonds and Treasury bonds were significantly more volatile in the second half of this period when credit-related securities became popular. In contrast, investment-grade bonds exhibited no significant change in volatility. The junk bonds variance ratios changed from being less than one to greater than one. Using the GJR-Garch model, the conditional volatilities of junk bonds increased in the second half of the period and the mean reversion speeds slowed, suggesting a longer time for mean reversion to occur. Our analysis rules out treasury volatility, credit spread level, equity market return, T-bill rate, curvature of the Treasury curve, financial crisis, quantity of defaults and standard deviation of defaults as explanations for the increase in junk bond volatility. In contrast, volatility of equity returns provides a partial explanation of junk bond spread volatility in the later period.     

Risk Changes around Calls of Convertible Bonds

We examine changes in equity and asset betas around convertible bond calls and report two major findings. First, calling firms exhibit an increase in asset betas following the call. We argue that the finding is consistent with the implications of the sequential financing theory but not of the backdoor equity financing theory. Second, abnormal returns at call announcements are negative only for the subsample of firms that also exhibit an increase in equity beta. We conclude that risk changes help explain the market reaction to convertible bond calls.     

Corporate bond credit spreads and forecast dispersion

Recent research establishes a negative relation between stock returns and dispersion of analysts’ earnings forecasts, arguing that asset prices more reflect the views of optimistic investors because of short-sale constraints in equity markets. In this article, we examine whether a similar effect prevails in corporate bond markets. After controlling for common bond-level, firm-level, and macroeconomic variables, we find evidence that bonds of firms with higher dispersion demand significantly higher credit spreads than otherwise similar bonds and that changes in dispersion reliably predict changes in credit spreads. This evidence suggests a limited role of short-sale constraints in our corporate bond data sets. Consistent with a rational explanation, dispersion appears to proxy largely for future cash flow uncertainty in corporate bond markets.     

Corporate Credit Spreads and the Sovereign Ceiling in Latin America

We exploit a panel of 72 US dollar-denominated bonds issued by Latin American publicly listed firms between 1996 and 2004, a period of regional financial crises, to answer the following three questions: (1) Is sovereign risk a statistically and economically significant determinant of the corporate credit spread, controlling for firm- and bond-specific characteristics? (2) If yes, do market participants apply the sovereign ceiling rule adopted by rating agencies in the pricing of our bond market data? And (3) how do market views compare with the rating agencies ceiling policy for each corporate bond? We find strong evidence of an economically and statistically significant effect of sovereign risk on corporate spreads across different panel econometric specifications and bonds. Moreover, markets do not apply the ceiling rule in 77–90% of the bonds we sample and these findings are consistent with rating agencies’ policies toward the latter for about 50% of the firms. These results are robust to the inclusion of firm- and bond-specific variables derived from the structural approach to credit risk and to the business cycle in each country.     

Illiquidity or credit deterioration: A study of liquidity in the US corporate bond market during financial crises

We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity effects are more pronounced in periods of financial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and find that liquidity effects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is significantly larger in periods of crisis, and for speculative grade bonds.