In any given country, government bonds are thought to be safer than corporate ones. After all, governments have the ability to tax or even print money through their central banks. This would suggest that corporate bond yields should generally be higher than government bond yields. And many investors think that government credit risk is a component of corporate credit risk. However, recent research by the Federal Reserve of San Francisco and Wharton Business School questions this line of thinking. In their paper, ‘Corporate yields and sovereign yields’, they find that when government bond yields are high, corporates can often issue at lower yields…
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In any given country, government bonds are thought to be safer than corporate ones. After all, governments have the ability to tax or even print money through their central banks. This would suggest that corporate bond yields should generally be higher than government bond yields. And many investors think that government credit risk is a component of corporate credit risk. However, recent research by the Federal Reserve of San Francisco and Wharton Business School questions this line of thinking. In their paper, ‘Corporate yields and sovereign yields’, they find that when government bond yields are high, corporates can often issue at lower yields.
What Data Do They Use?
They look at 137,717 private bonds issued between 1993 and 2017 and focus only on bonds issued in international markets. They cover 22 advanced economies and 22 emerging economies (including China). The source of their data is the widely used Dealogic DCM Analytics.
What Are Their Main Findings?
The researchers define two states of government bond yields: a low-yield one or a high-yield one. They calculate these by looking at the yields in real terms; that is, adjusted for inflation. Then, they look at trends and use some sophisticated statistical techniques (Markov Chains) to determine whether the government yields are in the low- or high-yield state.
With this information, they look at the relationship between corporate yields and government yields. They find that in a ‘low-yield’ world, corporate yields almost move 1-to-1 with government bond yields. However, in a ‘high-yield’ world, they find that corporate yields respond much less to sovereign yields (see Figure 1). This is surprising.
Figure 1: All Home-currency Bonds
Source: Corporate yields and sovereign yields, Page 25
Could Other Factors Be Causing This Relationship?
An obvious reason for this could be that corporate ratings actions could change their sensitivity to sovereign ratings changes in high-yield states. But the researchers find this is not the case. The relationship appears to be stable in both states. Nor does a country being on or off an IMF programme (or in crisis) alter the fact that high-yield states see a weaker relationship with corporate yields.
They also find that the types of corporates bonds issued do not vary much between low-yield and high-yield states. For example, issue size, maturity, and sectors broadly remain the same.
What Could Explain the Behaviour?
The authors of the paper construct a model to explain corporate yields that incorporates a more realistic version of government bond markets. In essence, they assume that government yields contain noisy information about the creditworthiness of the corporate bonds. The model shows that when government yields are high and more volatile, their information value for investors declines. This in turn weakens the link between corporate yields and government yields in a high-yield state of the world. This model appears to explain the observed behaviour in their analysis.
With so much focus on credit markets, this is a timely paper for investors. It’s main finding – that higher government bond yields may not impact corporate bond yields as much as many people think they do – should force investors to rethink their bearish scenarios for credit.
There are some caveats, though. The authors themselves are unsure why this relationship exists. More importantly, they didn’t look much at the interaction of unconventional monetary policy and credit markets, which may be skewing the results in recent years. Nevertheless, the paper highlights an empirical relationship that goes against what many people assume.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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