Corporate Bond Spreads and the Business Cycle

Abstract

The corporate bond market is becoming an important focus for more and more fixed-income market participants, and a growing number of fund managers require a valuation framework to enhance portfolio returns by altering their exposure to corporate bonds relative to government bonds. The authors model Baa corporate bond yields over Treasuries using forty years of quarterly data. The data includes annual changes in real GDP, the annualized “financing gap” of non-farm non-financial U.S. corporations as a percentage of GDP, and stock market volatility, defined as the standard deviation of daily returns on the S&P 500 index. The model indicates that credit spreads are currently above “fair value,” but are projected to fall modestly on average in the course of the year. This suggests that bond investors should overweight U.S. corporate bonds relative to government bonds.