Interest in UK corporate/gilt yield spreads has been heightened recently by sharp increases in both domestic and eurosterling spreads. There is a large literature, principally from the US, that assesses the determination of such spreads and stresses the direct link that one would expect default risk and hence the economic cycle. However, the literature also notes that such a relationship may be distorted by variations in market segmentation or liquidity. Moreover, market commentators in the UK have recently emphasised the potential importance of distortions arising from deterioration of the corporate bond market infrastructure (credit analysis, issuance) after the long period of low issuance other the late 70's and early 80's.
In this context, this paper seeks to assess the current usefulness in UK monetary policy formulation of credit quality spreads. Do spreads indicated or predict corporate defaults and the cycle? A number of econometric approaches are employed to test aspects of this hypothesis. The tests assess the 1968-89 period, also two sub-periods 1968-77 and 1978-89 and, as a "control", the US market where one would expect efficiency a priori.
The results, subject to the limitations of the analytical techniques (which can show the average performance of the market other the sample period), show a deterioration in UK market performance over time, which may be related to changes in factors such as liquidity and market segmentation. These imply, first, that spreads may not be a useful monetary indicator (though it would be wrong to disregard them entirely) and, second, that risk may be inaccurately priced in the UK domestic bond markets, an inefficiency that could lead to underuse of the market. Given similar patterns are observable in the eurosterling market, it may also be affected. In the US, by contrast, spreads are shown to be sensitive predictors of the cycle, defaults and other factors underlying financial fragility.
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