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The High-Yield Corporate Bond Spread and Economic Activity :: Timothy Bianco and Mehmet Pasaogullari :: Economic Trends :: 11.04.09 :: Federal Reserve Bank of Cleveland

Posted by LeGianT on March 16, 2010

The High-Yield Corporate Bond Spread and Economic Activity ::
Timothy Bianco and Mehmet Pasaogullari ::
Economic Trends ::
11.04.09 ::
Federal Reserve Bank of Cleveland

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.

While financial markets are essential to economic growth, they may also play a role in propagating the business cycle. Economists call this effect the “financial accelerator,” meaning that conditions in financial markets can perpetuate and amplify shocks to economic activity. One important channel through which the financial accelerator operates is the way investment is affected by the external finance premium. The external finance premium is the difference between the cost of external funds and the opportunity cost of internal funds. Borrowing from lenders is almost always more expensive for a firm than using its own funds because lenders must be compensated for the costs of evaluating and monitoring borrowers. Therefore, the external finance premium is generally positive. Moreover, it is inversely related to the strength of a firm’s balance sheet. Improvements in balance sheet strength will lower the premium, degradations will raise it. Changes in the premium affect the investment decisions of firms, which in turn affect real economic activity. It is because the value of a firm’s assets and the overall health of its balance sheet generally move positively with overall economic activity that financial market conditions can amplify the effect of shocks to economic activity.

Measures of this external finance premium may contain valuable information about future economic activity. Corporate bond spreads, in particular the high-yield spread—the spread between the yields of high-yield (or junk) bonds and higher-grade bonds (say, AAA corporate bonds)—might be a suitable measure for this premium. The yields of the former type of bond are especially sensitive to the default probabilities of firms; thus, 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. Moreover, the increases in this spread have preceded the last three recessions. 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 or the output gap.

As for the most recent recession, the high-yield spread started increasing in June 2007, about two quarters before the start of the recession. It rapidly increased between May 2008 and mid-December 2008. It stayed at these historically high levels until the end of March 2009. Since then, the high-yield spread has steadily come down, paralleling developments in other financial markets. The spread moved down to 6.7 percent at the end of September after a six-month steady decline from a high of 14 percent at the beginning of April 2009. It continued to go down in October and was 6.4 percent on October 28. This may serve as yet another observation for the continued normalization of financial markets since last spring. However, it should be noted that the high-yield spread is still about 2 percent higher than its mean for the past 21 years.

So, what does the high-yield spread forecast for real GDP for the rest of 2009 and 2010? A simple empirical model of GDP and the high-yield spread predicts that real GDP will grow 2.8 percent in 2010. Of course, estimates from such a simple model should be approached cautiously since the high-yield spread is just one indicator of future economic activity. Yet the forecasted trend is in line with most other forecasts in predicting an upward trend in the annual growth of real GDP in 2010.

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