Understanding the Impact of Monetary Policy Shocks on the Corporate Bond Market in Good and Bad Times: A Markov Switching Model

63 Pages Posted: 24 Jun 2016

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University - Department of Finance

Alexei G. Orlov

Securities and Exchange Commission

Manuela Pedio

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Date Written: April 1, 2014

Abstract

We study the effects of a conventional monetary expansion, quantitative easing, and operation twist on corporate bond yields and spreads. These policies are simulated as shocks to the Treasury yield curve, and the impulse response functions of corporate yields and spreads to shocks are computed using flexible models with regimes. We construct weekly bond portfolios sorting individual bond trades by rating and maturity using TRACE. The paper examines two types of models — single-state vector autoregressive (VAR) models and three-state Markov switching VAR models. Our results indicate that a standard single-state VAR model is inadequate to capture the dynamics of the data. We find that none of the policies — conventional or unconventional — can persistently lower corporate spreads. This result is likely due to the negative expectations about the business cycle generated by these policies, which affect bond risk premia. Operation twist is the only policy capable of lowering corporate yields. This finding can be explained by the fact that operation twist, which does not imply an expansion of the monetary base, is able to flatten the riskless yield curve without generating expectations of higher future inflation.

Keywords: Unconventional monetary policy, corporate bonds, term structure of Treasury yields, vector autoregression, Markov switching.

JEL Classification: G12, E43, C32

Suggested Citation

Guidolin, Massimo and Orlov, Alexei G. and Pedio, Manuela, Understanding the Impact of Monetary Policy Shocks on the Corporate Bond Market in Good and Bad Times: A Markov Switching Model (April 1, 2014). BAFFI CAREFIN Centre Research Paper No. 2016-23, Available at SSRN: https://ssrn.com/abstract=2799633 or http://dx.doi.org/10.2139/ssrn.2799633

Massimo Guidolin (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Alexei G. Orlov

Securities and Exchange Commission ( email )

100 F Street NE
Washington, DC 20549
United States

Manuela Pedio

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Sarfatti, 25
Milan, 20136
Italy

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