Sentiment and Corporate Bond Valuations before and after the Onset of the Credit Crisis

Abstract

Stock market sentiment is an important driver of corporate bond valuations. Using transactions from the Trading and Compliance Engine (TRACE), the authors find that sentiment is negatively related to bond yield spreads, with the impact being stronger after the onset of the recent financial crisis. The negative effect of sentiment on yields is stronger when fundamental risk and liquidity frictions are higher, which points to a direct role of sentiment in the bond market whereby rational bond investors are unable in these high-risk/high-friction scenarios to correct the mispricing generated by other bond investors. The authors also find that the sentiment effect is stronger when the returns to capital structure arbitrage are higher, suggesting that sentiment also spills over to the bond market through the activity of invesinvestors dedicated to correcting relative stock and bond value mispricings within the same firm. They further provide evidence that after the onset of the crisis, sentiment also helps explain the extent to which the corporate bond market and the equity market are integrated.