Cash Flow Volatility and Corporate Bond Yield Spreads

Abstract

We conduct a detailed empirical study of the effects of cash flow volatility on corporate bond yield spreads. Using a lengthy sample of transaction prices for investment grade straight bonds, we show that cash flow risk has strong statistical significance and economic effects on spreads, after controlling for a large number of factors which are known to be important determinants of spreads such as equity return volatility, credit rating, time to maturity, coupon rate, interest coverage ratio, leverage ratio, etc. The effects of cash flow risk are magnified considerably for firms that are at greater risk of default, as proxied by either relatively low interest coverage ratios or relatively low credit ratings. We consider several alternative ways to measure cash flow risk. While all of them exhibit strong statistical and economic significance, the squared difference between the current quarter's cash flow relative to that from the same quarter in the preceding year stands out as being particularly important.

Keywords: Corporate bond yield spreads, cash flow volatility, equity return volatility, credit ratings, regime-switching

JEL Classification: G11, G12