What Drives Spreads in the Euro Area Corporate Bond Market?

The aim of this paper is to identify the financial and macroeconomic factors driving European corporate bond spreads. Specifically, we want to investigate the relationship between corporate bond spreads and the equity market and obtain a model that can help to explain and forecast movements in the spread itself. For this purpose, following Campbell, Lettau, Malkiel and Xu (2001), we decompose the volatility of the market index return in its components – market, industry and firm volatility – and use them as explanatory variables together with the equity market return.

Using monthly data, from February 1996 to October 2009, we explain the corporate bond spread with an autoregressive model including the short-term spot interest rate, the slope of the interest rate curve, variables related to the Merrill Lynch investment-grade index structure, two dummy variables for the most recent economic recessions as well as the returns on the Dow Jones Eurostoxx 50 and the volatility components of the same equity index. Our results are quite different from Campbell e Taksler (2003), who study a similar model for the US corporate bond market. The authors find evidence for a different behaviour of the US equity and corporate bond markets in the nineties and attribute it to an increase in idiosyncratic volatility. Specifically, greater idiosyncratic volatility had contributed to raise equity prices and, at the same time, to depress corporate bond prices. Instead, our analysis reveals that the Euro area corporate bond spread is driven by the market volatility component as well as the equity index return.

It is possible that the difference in results could be partly explained by the different liquidity condition of the bond markets over the two periods considered. To investigate the effect of liquidity we therefore decompose the corporate spread into its components and isolate the premium for credit risk which should be related to the volatility of the equity market. Following Churm and Panigirtzoglou (2005), and Leland and Toft (1996), we obtain an estimate of the credit risk part of the corporate spread as the sum of the compensation for expected default and the compensation for the uncertainty about default and recovery rate, and calculate the non-credit risk component (mainly a liquidity premium) as a residual. We then estimate our model again using the credit premium component as our independent variable and obtain that both idiosyncratic volatility and market volatility are now significant. We therefore find some evidence that the difference between our analysis and Campbell and Taksler is due to the difference in liquidity in the corporate bond market over the two different sample periods. Put differently, it is possible that the relevance of the liquidity effects in our sample period (in particular between 2005-2006 and from August 2007, characterised respectively by a high degree of liquidity and a lack of liquidity) reduces the significance of the idiosyncratic component.

Finally, our spreads model has a great goodness of forecast both at a monthly and quarterly horizon.