Ebook Explaining the Increased German Credit Spread: The Role of Supply Factors
Since 1999 an increase in magnitude and volatility of the yield spread between corporate and government bonds is not only observable in the US bond market, but also in the German bond market. This so called quality or credit spread is defined as the inter-market yield difference between seasoned non-government and seasoned risk-free government bonds, which are assumed to be identical in all respects except for credit quality.
Much academic work interprets this spread as a measure of market’s perception of the credit risk implied with corporate bonds. Since highly rated corporates have little probability of default, the credit spread seems too large to be explained solely by default risk premium. Additionally some studies reveal a low explanatory power of the default risk for the level as well as for the changes in the US corporate yield spread. In recent literature the yield spread is regarded as a measure of a comprehensive risk premium to compensate investors for a number of risks associated with corporate bonds. Furthermore a possible influence of demand and supply factors triggering the observed recent variations in the spread is discussed. Published empirical work has concentrated though almost uniquely on the US bond market, only very few studies are available for the German market.
The purpose of this paper is to analyse the credit spread of the German corporate bond market, focussing on the one hand especially on the recent period of high volatility of the credit spread and on the other hand on possible influences of structural demand and supply effects. We apply a twofold approach in pursuing our purpose.
Firstly, based on the theoretical and empirical literature we determine the single factors influencing the credit spread and possible proxies to capture their impacts in order to provide a framework to base our empirical estimations on.
Secondly, we attempt to examine empirically the credit spread of German corporate bonds over German government bonds covering monthly time series from July 1975 to June 2003. We estimate a linear error correction model using different proxies to capture possible demand and supply effects and perform forecasts to detect the variables explaining the increased magnitude and volatility of the credit spread. Additionally we employed econometrically plausible instruments to isolate these effects.
Our results are not clear-cut, which is partly related to the unavailability of sufficiently adequate data to disentangle all effects of the various determinants. Nonetheless we can support findings of previous studies and offer additional findings for the German bond market in line with our purpose. We provide evidence on significant impact of supply effects on the credit spread and our forecasts trace the high volatility of the spread surprisingly well, hinting at variables triggering this development.
The remainder of this paper is organized as follows: following our twofold approach, in the next section we survey related literature to isolate the single determinants. In the third section we pursue the second line of our approach. In the first part of this section, after presenting our methodology, we specify our model and discuss our data. In the second part we present and discuss the results of our estimations and provide some interpretation. The fourth and last section of this paper contains concluding comments.
Contents
I. Introduction
II. Survey of the theoretical and empirical literature
- II. 1 Default risk and risk premium
II.2 Liquidity effects
II.3 The risk-free term-structure of interest rates
II.4 Term to maturity
II.5 Demand and supply effects
II.6 Measurement biases
III. Modelling the german credit spread using an error correction model
- III.1 Methodology, model and data
III.2 Results and interpretation
IV. Conclusion
References
Appendix A: Graphical presentations
Appendix B: Tables
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