Bond Spreads and Economic Activity in Eight European Economies

We provide new insights into the relationship between financial market tightness and real activity using a new database of corporate bonds issued in eight European countries. Bond spreads have a significant negative relationship with four real activity variables at horizons 1-8 quarters ahead. The relationship is robust to adding measures of monetary policy tightness and leading indicators, providing strong support for models previously only evaluated on US data. A sub-set of northern European countries have similar sensitivity of real GDP to bond spreads, but others have greater sensitivity to bond spreads, revealing diverse responses in Europe to financial market tightness. The global financial crisis that began in 2007 and the ensuing recession have spurred renewed interest in the relationship between tightness of financial markets and the business cycle. A number of studies have considered the effects of financial conditions on the real economy (Hatzius et al. 2010, Cardarelli et al. 2011, and others summarised in Kliesen et al. 2012). New models that develop the financial accelerator idea of Gertler and Gilchrist (1994) and Bernanke et al. (1999) incorporate “risk shocks” emanating from the financial sector that are then transmitted to real output (e.g. Gertler and Karadi, 2009; Jermann and Quadrini, 2012). A negative risk shock means that borrowers can finance less investment for a given net worth. Attention has focused on corporate bond markets, which have increased in significance since the financial crisis because of the reduced availability of bank finance (Kaya and Meyer, 2013; Kaya and Wang, 2014). The yield spread between corporate bonds and lowest-risk government bonds reflects investors’ willingness to lend to companies and incorporates two time-varying components: the default risk itself, and systematic risk associated with the fact that expected default loss is correlated with equity price movements (Elton et al. 2001). 2 Even before the crisis (Gertler and Lown, 1999; Mody and Taylor, 2004; and King et al., 2007) had shown that high yield bond spreads have predictive power for output fluctuations in the United States. The most recent research on the relationship between bond yields and real activity has been conducted by Gilchrist et al. (2009a), Gilchrist and Zakrajšek (2012) and Faust et al. (2013) on US bond market data. They confirm that changes in bond spreads offer early warnings of a decline in real activity, so that they are powerful indicators of approaching 1 We thank the ESRC for funding under grant number ES/H003053/1. We benefitted greatly from comments of the editor, Morten Ravn, and three anonymous referees as well as seminar participants at the Bank of England; the Money, Macro and Finance conference, Dublin, Sept 2012; and Yonsei University, Seoul. We thank Robert Anderton, Gabe de Bondt, John Duca, John Gathergood, Simon Gilchrist, Christoph Görtz, Michael Joyce, Peter Karadi, Kevin Lee, Phil Molyneux, Simon Price, Peter Sinclair, Oreste Tristani, Philip Vermeulen, Mark Watson, Mike Wickens, Vladimir Yankov and Egon Zakrajšek for additional comments. Any remaining errors are our own. Corresponding Author: Paul Mizen, Professor of Monetary Economics, University of Nottingham, University Park, Nottingham, NG7 2RD, United Kingdom; Email: paul.mizen@nottingham.ac. uk. 2 As Elton et al. (2001), p. 267) put it, “[i]f corporate bond returns move systematically with other assets in the market whereas government bonds do not, then corporate bond expected returns would require a risk premium to compensate for the non-diversifiability of corporate bond risk, just like any other asset. ” 1 recessions. Rather than use an off-the-shelf index, these latest contributions employ a bottomup approach that concentrates on the careful selection of bonds to create a bond spread index that is not distorted by embedded options or illiquidity. While these papers provide convincing evidence that bond spreads predict future changes in real activity in the United States, there is no corresponding analysis for the euro area and the United Kingdom, the second and third largest bond markets respectively, mainly because these bond markets are comparatively young, but also because of a lack of country-specific bond indices.3 We construct corporate bond indices for eight European countries, using the approach pioneered by Gilchrist et al. (2009a). This provides the first measures of corporate bond market tightness specific to each country, which can be used to explore hypotheses previously only tested on US data. Our paper makes several contributions to the literature with potentially important policy implications for European economies. The first main contribution is to show that bond spreads have significant predictive ability over macroeconomic variables for the largest European economies, providing a signal of incipient economic downturns in these countries. We evaluate the importance of the bond spread versus measures of domestic monetary policy tightness and leading indicators, as well as spillover effects from regionally or globally important economies such as the United States and Germany, and find that bond spreads offer a substantial contribution to the prediction of real activity. Our second main contribution exploits the cross-sectional dimension of our data to compare the responses to the bond spread measures in different countries across Europe. There is a high degree of consistency in the statistical significance of the bond spread measures at different horizons for each country, with a commonly signed negative coefficient in a regression explaining real GDP growth. But the scale of the response is not equal, reflecting heterogeneity in the sensitivity of different European countries to financial conditions, measured by corporate bond spreads. These may reflect the differences in the depth of capital markets among the countries in the sample. When we test for equality of the bond spread coefficients across all European countries (including the UK), we reject the null, and for euro area countries alone we also reject the null of equality. But for a subset of euro area countries with the largest corporate bond markets (Germany, France and Netherlands), we cannot reject the null that the coefficients on bond spreads are equal. In addition to the fact that bond spreads differ in magnitude across Europe, the sensitivity of the response of real GDP to these spreads is also greater for Austria, Belgium, Italy and Spain than it is for France, Germany and the Netherlands. A financial shock may raise spreads by larger amounts in some peripheral economies of Europe; our paper shows that the impact on real GDP in those economies is also greater due to higher sensitivity of activity to spreads. This implies that the impact of bond spreads on real activity measures differs across countries in Europe, despite a common monetary policy stance, and considerable real economic ties between countries. In addition to these contributions, we also decompose the spread by removing the influence of default risk and bond characteristics before testing the information content in the 3 European bond markets had $1933.3bn of outstanding corporate bonds in December 2013, of which $1229.2bn were issued in euro and $704.1bn in sterling. They are the second and third largest bond markets, respectively, after the United States, according to data from the Bank for International Settlements. 2 residual bond spreads (the “excess bond premium”). 4 This confirms the predictive ability of the spread even after purging it of these potentially distorting factors. We find that bond spreads in the euro area are correlated with the tightness of credit supply as reported in ECB surveys of bank lending, and we show that a worsening of bank credit supply has a significant negative correlation with future real GDP growth, whereas a survey measure of credit demand does not.5 Our interpretation of these results is that tightness of credit supply from banks and bond markets occurs at the same time and has a similar degree of predictive ability over real activity. Finally, in an online appendix, we show that our model has superior out-of-sample forecast performance in forecasting real GDP growth relative to that of a model that omits bond spreads, and other basic alternatives such as a random walk model and an autoregressive model. Our findings are evaluated using our unique new panel of data from October 2001-May 2011 for Austria, Belgium, France, Germany, Italy, Netherlands, and Spain and from July 1994-May 2011 for the United Kingdom.6 This index is the first of its kind for Europe, where there are no benchmark indices for bond spreads over a comparable sample period, and data on European bonds has not been systematically constructed into a bond spread index. The paper is organised as follows. Section 1 discusses the recent literature. We then explain recent developments in European corporate bond markets and differences between countries, and the nature of our data in Section 2. In Section 3 we explain our methodology. Section 4 then provides results of the predictive ability of bond spreads on real economic activity and tests various hypotheses about cross country differences, out of sample forecast performance and the relationship to bank lending surveys. Section 5 concludes. 1. A Brief Review of the Literature In an early contribution Davis and Fagan (1997) tested for the predictive content of the bond quality spread (defined as the difference between private and government bond yields) for three European countries (Denmark, Germany and the UK). They found a significant relationship for bond spreads only in Germany for inflation and output growth, but their out-of-sample forecasting results were weak. De Bondt (2004) offered the first empirical examination of the balance sheet channel in the euro area since the introduction of the single curr