Cost of borrowing for corporations changes with changing credit market conditions. For example, tightening credit market conditions would result in an increase in the cost of borrowing for most firms in the economy. Imperfect capital market theories predict that the change in the cost of borrowing due to changing credit market conditions would be different for firms with different characteristics.
For example, the cost of borrowing for firms with high probability of default should increase more with tightening credit markets than the cost of borrowing for firms with low probability of default. Further more, the effect of credit market conditions on cost of borrowing for firms with different characteristics might vary over the business cycle. Firms with high probability of default might become even more financially distressed in economic recessions resulting in a higher increase in the cost of borrowing with respect to firms with low probability of default.
In this paper, we analyze the effect of changing credit market conditions on the cost of borrowing for firms with different characteristics over the business cycle. Specifically, we use the federal funds target to proxy for changing credit market conditions as it affects all yields in the economy including yields on corporate bonds. To capture unexpected changes in the fed funds rate, we follow Kuttner (2001) and Bernanke and Kuttner (2005) and use the 30 day futures on the fed funds rate. We use the difference in the yields of Moody’s BAA and AAA rated bond indices to capture the difference in the cost of borrowing for firms with different probabilities of default. The difference in the yields of Moody’s BAA and AAA rated indices is a widely used measure of default (credit) spread and captures the differential cost of borrowing for firms with high default risk.
We first analyze the reaction of daily default spread to unexpected changes in the federal funds rate on days when there is either an FOMC meeting or an unannounced change in the fed funds rate. We find that the yields on AAA and BAA bonds do not react significantly to neither expected nor unexpected changes in the federal funds target rate. On the other hand, the default spread increases significantly when there is an unexpected increase in the federal funds target rate. Specifically, a one basis point unexpected increase in the federal funds rate increases the default spread by 3 basis points.
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