The Effect of Monetary Policy on Credit Spreads

Abstract

We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions. Significant at the 10% level. t is the monthly return on the S&P 500 index. Panel A presents results based on the NBER recession dummy variable (NBER t ), which equals 1 if the economy is in a recession in month t as defined by the NBER, and 0 otherwise. Panel B presents results based on the (log) growth rate of industrial production ( ln IP t ). Panel C presents results based on the real-time recession probabilities from the estimation of equation (1). Panel D presents results based on the real-time recession probabilities from Chauvet and Piger (2008). The coefficients are estimated via OLS with HAC standard errors.

The impact of interest rates on firms' financing policies

“…Further, the empirical studies provide some evidence that macroeconomic and market conditions significantly impact bond yields and firms' financing decisions. Cenesizoglu and Essid (2012) find that the positive impact of unexpected monthly changes in the Fed funds target rate on monthly changes in credit spreads between Moody's Baaand Aaa-, Aa-, and A-rated bond indices is only significant during recession periods. Baum et al (2009) find that firms' short-term leverage decreases with macroeconomic uncertainty measured as the conditional variance of the detrended index of leading indicators.…”

A reduced form model of default spreads with Markov-switching macroeconomic factors

“…Davies (2004) finds that this is indeed the case and that a Markov-switching model summarizes some properties of spread times series well while Bruche and González-Aguado (2010) finds switching behavior in default rates and recovery rate distributions. Cenesizoglu and Essid (2010) also provide evidences of switching behavior while examining the effect of monetary policy on credit spreads.…”

The efficacy of macroeconomic policies in resolving financial market disequilibria: A cross‐country analysis

“…In summary, these results indicate that central bank interest rates should be reduced in order to decrease credit spreads and, ultimately, resolve financial market disequilibria. Essentially, a reduction in central bank interest rates facilitates lending operations and reduces volatility within financial markets (Cenesizoglu & Essid, 2012). Though some of these regression models may not be sufficiently reliable, 13 different countries indicate a significant relationship between central bank interest rates and credit spreads.…”

“…Furthermore, in line with Cenesizoglu and Essid (2012), both a VAR analysis and a linear regression analysis will be conducted to evaluate the effects of liquidity provision on credit spreads and the efficacy of central bank interest rates in mitigating financial market disequilibria. Additionally, Cenesizoglu and Essid (2012) posited that changes to credit spreads might be due to the lack of control variables. Hence, both uncontrolled and controlled linear regression analyses will be conducted.…”

“…In evaluating the effect of liquidity provision on credit spreads, both uncontrolled and controlled regressions were conducted, which allows the real effects of liquidity provision to be elucidated by accounting for other exogenous variables that may impact credit spreads (Cenesizoglu & Essid, 2012). VARs were then conducted to analyse the short-term impact of liquidity provision on credit spreads.…”