Magazine article Economic Trends

An Update on the High-Yield Corporate Bond Spread and Economic Activity

Magazine article Economic Trends

An Update on the High-Yield Corporate Bond Spread and Economic Activity

Article excerpt

12.22.09

The financial crisis has brought into focus the importance of financial markets to a properly functioning economy. These markets help the economy allocate resources and shape the investment and saving decisions of the society. One important financial market is the corporate bond market. A look at current conditions in it can shed some light on ongoing financial market stabilization.

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The spreads between the bonds of companies with different credit ratings indicate investors' attitudes toward risk and may contain valuable information about the state of economy. The high-yield spread is a corporate bond spread that might be particularly good to look at for this kind of information. The high-yield spread is the spread between the yields of high-yield (or junk) bonds and higher-grade bonds (say, AAA corporate bonds). The yields of junk bonds are especially sensitive to the default probabilities of firms, which varies over business cycle, so these yields are likely to be a good predictor of future economic activity.

There is a negative relationship between economic activity and the high-yield spread. This can be seen in the relationship between the high-yield spread (defined here as the spread between the yield of the Merrill Lynch High Yield Master II Index and the Merrill Lynch AAA corporate bond index) and GDP growth or the output gap.

Increases in this spread have preceded recessions. This pattern was also observed in the most recent recession: The high-yield spread started increasing in June 2007, about two quarters before the start of the recession. …

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