An empirical analysis of the relationship of bond yield spreads and macro economic factors

Abstract

This study develops and tests a model that explores the relationship between bond yield spreads for various industries, as represented by the spread between corporate and equivalent government bond yields, and the business cycle/economic environment while at the same time controlling for default risk, tax implications and issue traits, such as liquidity, callability and the existence of sinking fund. The overall sample consists of over 50000 quarterly observations for individual corporate bonds in the industrial, utilities and transportation sectors over the period September 1990 to March 1996. The results confirm the typical direct relationship between default risk and yield spreads. More importantly, it is found that the impact of the business cycle (macro economy) on the yield spread of a corporate bond depends on the industry sector to which the issuer of the bond belongs. Thus, while in the industrial sector, bond yield premia are generally higher during recessionary periods (periods of lower industrial production), the opposite is true for utilities.

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