An Update on the High-Yield Corporate Bond Spread and Economic Activity
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.
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. Since March 2009 the high-yield spread has steadily come down, parallel to the developments in other financial markets. The spread moved down to 6.4 percent at the end of October after a seven-month steady decline from a high of 14 percent at the beginning of April 2009.
The high-yield spread increased 0.1 percent in November, since the AAA corporate bond yield declined by about 0.3 percent, whereas the high-yield bond yield declined about only 0.2 percent. However, in the first half of December, the AAA corporate bond yield increased 0.3 percent whereas the high-yield bond yield continued to decline. By December 15, the spread had declined to 5.8 percent.
Employing a simple empirical model of GDP and the high-yield spread, we forecast that real GDP will grow 2.7 percent in 2010. This is 0.1 percent lower than October’s forecast using the same method. The difference mainly reflects the downward revision to GDP in the third quarter of 2009. It should be noted that estimates from such a simple model should be approached cautiously since the model utilizes only one of the many possible indicators of future economic activity. Still, the forecasted trend is in line with most other forecasts in predicting an upward trend in the annual growth of real GDP in 2010.