The factors impacting on corporate bond spreads
One of the main issues related to financial stability in the past decade, in Israel and abroad, is the increased prices of corporate bonds, and the decline in credit spreads inherent in their prices, despite the decline in their rating and the increase in the risks incorporated in them. The low yield and interest rate environments globally and domestically, and the high liquidity and the search for yield in recent years supported the increase in financial asset prices, particularly prices of corporate bonds. This asset is a central part of the public’s asset portfolio and one of the business sector’s main source of financing. In this research, the economists estimate the impact of fundamental economic factors on corporate bond spreads in Israel. Based on tradable corporate bonds data in 2007–20, the researchers examine if, when, and in what bond groups there was a prolonged deviation of the actual spread from the spread forecasted by the fundamental factors.
Alongside the changes in corporate bond prices and spreads over the years there was notable activity of the public’s investments in the asset, particularly investment through mutual funds specializing in purchasing corporate bonds. Past experience indicates that when there is a rising bond market, the public increased its holdings in corporate bond mutual funds, and in downturns, the public rapidly redeemed its savings in those types of mutual funds. Therefore, the economists also examine the contribution of corporate bond mutual fund developments to explaining the deviation of actual spreads from spread forecasts based on fundamental factors.
It was found that rapid net aggregate inflows of money into corporate bond mutual funds contributed to strengthening the trends of deviation from the forecast spreads in the market, primarily in the period after the 2008 crisis. The researchers learn from this that rapid net aggregate inflows of money into corporate bond mutual funds has the potential to increase the corporate bond market’s vulnerability. In periods of rising prices, and to the extent that corporate bond spreads are lower than those forecast based on fundamental factors, rapid net new aggregate inflows contribute to rising prices and to an additional increase of the deviation from the forecast spread. When the trend changes, rapid negative new accumulation is liable to accentuate trends of declining price and rising spreads to beyond those forecast in accordance with the fundamental factors.
The results of the research and the methodology developed by the researchers as part of the research, serve the Bank of Israel in ongoing monitoring of the corporate bond market as part of its efforts in maintaining financial stability.