The Relation Between Short-term Risk-free Interest Rates and Corporate Bond Yield Spreads under Market Anomaly
Post by MSF Chula at Monday, 27 August 2018 12:50 PM

The relation between risk-free rates and corporate bond yield spreads has been studied for a long time. Among the most widely-accepted models, Merton (1974) predicts that the corporate bond yield spread should decrease when treasury yield increases. In general, investors tend to invest more in risky assets and limit their long positions on risk-free assets when the economy is good. The decreasing demand for treasury bonds creates pressure on treasury bond prices, thus higher yields. Meanwhile, the increasing demand for risky corporate bonds results in higher prices and lower corporate bond yields. In a normal situation, therefore, market should expect negative relationship between risk-free rates and corporate bond yield spreads.

This paper aims to investigate the relationship between risk-free rates and credit spreads under market anomaly in which the lowered risk-free rates are not the result of bad macroeconomic conditions. Instead, the risk-free rates become lower because of favorable investment environments that attract foreign funds. When corporate bonds are not subject to high risk of default, the credit spread on the investment-grade bonds remain constant or decrease despite the decrease in risk-free rate.

Last updated at Monday, 27 August 2018 12:50 PM