Corporate bond yield spreads in recent decades: an examination of trends, changes, and stock market linkages

Business Economics, Jan, 2004 by Douglas J. Lamdin

Corporate bond interest rates are a subject of concern to investment analysts, corporate financial managers, and scholars. In this article the yield spreads between corporate bonds and government bonds and the spreads between differing quality corporate bonds are examined during recent decades. Also, the relationship between yield spreads and stock market movements is examined. Yield spreads vary considerably over this period, and have varying trends. Causality tests show that stock market movements precede changes in yield spreads.

Corporate bond interest rates and associated yield spreads are core topics in financial economics. What determines the level of and changes in these variables is important to a variety of financial analysts. An examination of these variables and the relationships between them, as well as possible linkages between yield spreads and stock market behavior, is the focus of this article. In particular, changes in yield spreads between high and medium quality corporate bonds and Treasury bonds are examined, as are changes in the spread between the differing quality corporate bonds. How these may relate to aggregate stock market behavior is considered. At issue is the extent to which changes in yield spreads and stock valuation may be linked in a predictive way.

The findings of this study should matter to both practitioners and scholars. Practitioners such as security analysts, portfolio managers, investment bankers, and corporate financial managers will find these results of interest as they seek to improve their decision-making processes. For example, asset allocation decisions and the timing of bond issues would be of concern to them. Scholars seek to better understand the workings of financial markets and how they might have changed in recent years. Financial market activity also has an impact on the real economy as interest rates affect investment at the firm level and at the macroeconomic level. (1)

The structure of the article is as follows. The next section discusses how and why the variables of interest have changed over recent decades. Data on these variables are examined to detect trends and changes in these variables from 1970 to the present. Thus, the data examined are timely and cover a sufficient period to discern long-term trends. As will be shown, there has been much variation in these variables. The third section examines changes in the equity risk premium (ERP) during this period. The ERP is the additional return that equity investors expect to earn above the risk-free return on government bonds. Recent research suggests that the ERP has declined, and thus it might be related to bond yield spread behavior. The next section describes econometric causality tests. These are then used to examine the possible relationship between movements in yield spreads and stock market movements. A final section concludes and discusses the significance and implications of the results.

A Preliminary Examination of the Data

Variations in interest rates are a given in financial market history. Changes in macroeconomic factors such as inflation and the business cycle cause these fluctuations. Investor perception of risk, of course, affects both interest rates and stock market valuations. Interest rates tend to move together due to common influences, such as inflation. Although this is true, the difference between corporate and government bond interest rates, and between corporate bonds rates on different quality bonds is not constant. This difference is the yield spread (or default spread, or quality spread). In general, when economic uncertainty is higher, such as during recessions, these spreads widen. (2)

Yield spreads on different risk-classes of bonds will reflect the perceived relative risk of these assets, other things (primarily maturity) being equal. Just as the difference between the expected return on corporate bonds and government bonds will reflect primarily the default risk of corporate bonds, so will differences in yields across corporate bonds. For example, Moody's ratings of corporate bonds (e.g., Aaa, Baa and so on), show that the higher the risk, the higher the expected return necessary to compensate investors.

The concern here is with the time-series behavior of bond rates and yield spreads. Monthly data from February 1970 to May 2003 were collected for the current promised yield on Aaa and Baa corporate bonds and 10-year Treasury bonds. (3) During this period, the monthly promised yield on the Treasury bonds (T) averaged 7.93 percent with a standard deviation of 2.38 percent. For Aaa bonds, these values were 8.87 percent and 2.08 percent. For Baa bonds these values were 9.98 percent and 2.40 percent. The (Aaa--T) yield spread averaged 0.95 percent during this period, with a standard deviation of 0.48 percent. The (Baa--T) yield spread averaged 2.05 percent with a standard deviation of 0.58 percent. The (Baa--Aaa) yield spread averaged 1.10 percent with a standard deviation of 0.43 percent. These statistics provide a sense of the size and degree of dispersion of these variables but do not tell us how the rates or spreads move together, nor do they tell us of any trends in them.