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Policymakers will not find it easy in real time to identify these elements correctly and to quantify the impact on underlying asset substitutability. What often becomes clear in retrospect (eg incipient rises in bond market volatility related to worries about fiscal deficits, leveraged positions in interest rate markets holding down long-term yields etc) will not be so obvious at the time. Nor is there any reason to suppose that the degree of asset substitutability will be constant across countries. In particular, it is likely to be lower in smaller or less developed financial markets. Hence the central bank. | Credit Spreads and Interest Rates A Cointegration Approach Charles Morris Federal Reserve Bank of Kansas City 925 Grand Blvd Kansas City MO 64198 Robert Neal Indiana University Kelley School of Business 801 West Michigan Street Indianapolis IN 46202 Doug Rolph University of Washington School of Business Seattle WA 98195 December 1998 We wish to thank Jean Helwege Mike Hemler Sharon Kozicki Pu Shen Richard Shockley Art Warga and the seminar participants at Indiana University and the Federal Reserve Bank of Kansas City. We also thank Klara Parrish for research assistance. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System. Credit Spreads and Interest Rates A Cointegration Approach Abstract This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. The positive long-run relation between spreads and Treasurys is inconsistent with prominent models for pricing corporate bonds analyzing capital structure and measuring the interest rate sensitivity of corporate bonds. 1. Introduction Credit spreads the difference between corporate and government yields of similar maturity are a fundamental tool in fixed income analysis. Credit spreads are used as measures of relative value and it is common for corporate bond yields to be quoted as a spread over Treasuries. In this paper we use a cointegration approach to provide an alternative model of credit spreads and analyze how credit spreads respond to interest rate movements. We find that corporate rates and government rates are cointegrated and the relation .
