How does the corporate bond market react to financial market volatility?
The Russian invasion of Ukraine has increased uncertainty in the world. Although most US companies have limited direct exposure to Ukrainian and Russian trading partners, heightened global uncertainty may still have an indirect effect on funding conditions by tightening financial conditions. In this article, we examine how US corporate bond market conditions have evolved year-to-date through the lens of the US Corporate Bond Market Distress Index (CMDI). As described in a previous Economy of Liberty Street a posteriori, the index quantifies the joint dislocations on the primary and secondary markets of corporate bonds and can thus serve as an early warning signal to detect a dysfunction of the financial markets. The index rose sharply from historic lows before the invasion of Ukraine, peaking on March 19, but appears to have stabilized around the median historic level.
CMDI is a unified measure of market functioning
The CMDI combines information on various aspects of the functioning of the primary and secondary US corporate bond markets into a single measure, as described in detail in our staff report. Ranging from 0 to 1, a higher level of CMDI corresponds to historically extreme levels of dislocation. The graph below plots the evolution of the CMDI since the beginning of the year, with event lines on February 24 (beginning of the invasion of Ukraine) and March 16 (date of the Federal Committee of the March open market). [FOMC] meeting where the target range for the federal funds rate was raised for the first time since 2019). The CMDI started 2022 at historically low levels – below the fifth percentile – suggesting that conditions in the primary and secondary corporate bond markets were at historically accommodative levels. The graph shows that the rise in global uncertainty precipitated by the invasion of Ukraine corresponded to a rapid increase in the CMDI, which peaked at the sixty-first percentile during the week ending March 19, but is thereafter returned to the twenty-third percentile in the week ending May 28.
CMDI grew rapidly after the invasion of Ukraine, but has since leveled off
In addition to looking at how conditions have changed in the corporate bond market as a whole, we can also compare incremental changes in conditions for investment grade bonds— that is, those rated Baa-/BBB- or above — and high-yield bonds. The following chart shows that market functioning deteriorated significantly for investment grade bonds, peaking at the seventy-fourth percentile in the week ending March 19. While increases in global uncertainty have coincided with monetary policy tightening, the greater deterioration in market functioning for higher quality bonds suggests that uncertainty may have played a more important role than politics. currency in the evolution of the functioning of the entire market. Market conditions for higher-rated corporate bonds are less sensitive to changes in monetary policy than those for high-yield bonds; for example, because the average maturity of high yield bonds is shorter, which increases the likelihood that high yield issues will be refinanced at higher interest rates.
Market functioning deteriorated faster for investment grade bonds
What motivates the recent movements of the CMDI?
To better understand what has driven the recent changes in the CMDI, we look to the contributions of the six underlying sub-indices – secondary market volume, secondary market liquidity, secondary market duration-adjusted spreads, spreads adjusted by secondary market default, primary market issue and the spread between primary and secondary market prices – at the level of CMDI squared. The way the CMDI is constructed, the square of the index can be written as the sum of the contributions of the individual sub-indices. The following graph shows that, although a slowdown in emissions was the most notable contributor to the CMDI level in early 2022, the deterioration following the invasion of Ukraine on February 24 can initially be attributed to the conditions of trading in the secondary market, with a decline in average trade size and buy-to-sell ratio and an increase in turnover. The peak for the week ending March 19 coincided with a deterioration in the default-adjusted spread sub-index, suggesting greater risk compensation to bear default risk, and a deterioration in the spread between primary and secondary market, suggesting a reduced willingness by market participants to intervene in the primary US corporate debt market.
Primary and secondary market conditions drive changes in the CMDI
Overall, this graph highlights the wealth of information encoded in the CMDI. By combining information from the primary market and the secondary market, the CMDI is better able to grasp the overall functioning of the market. CMDI deteriorations are not due solely to secondary market credit spreads or secondary market liquidity, but rather reflect the balance of conditions in the primary and secondary market.
Monetary policy tightening and corporate bond market conditions
Although we have focused so far on the potential impact of rising global uncertainty, the stance of monetary policy and market participants’ perception of the stance of monetary policy have also changed during this period. The FOMC voted to increase the target range for the federal funds rate at the March 15-16 FOMC meeting and financial market participants expect continued rate increases at upcoming FOMC meetings (see here). A natural question to ask in this context is to what extent variations in the CMDI can be attributed to monetary policy rather than global uncertainty. The charts above show that the functioning of the investment grade market deteriorated faster than that of the high yield market, and that the initial deteriorations in the overall index were mainly driven by measures of the volume of the secondary market rather than spreads, suggesting that the initial deterioration in market functioning between February 19 and March 19 is unlikely to have been driven by monetary policy. An alternative approach to assessing this issue is to compare the recent movement of the CMDI to the movement of the CMDI over a comparable period prior to the FOMC meeting on December 15-16, 2015, the start of the previous tightening cycle. The following chart shows that the CMDI was actually down prior to the December 2015 FOMC meeting, providing further evidence that the anticipation of monetary policy tightening does not necessarily translate into an immediate deterioration in market functioning. corporate bonds.
The CMDI did not have an overreaction to the tightening of monetary policy
Is everything calm on the corporate bond market front?
Although the CMDI has retreated somewhat from its March 19 high, it remains significantly above its 2021 average levels. In other words, while the corporate bond market continues to operate at historically average levels, market functioning has deteriorated compared to the recent past. It is therefore important to continue to monitor conditions in this market as the geopolitical situation and the monetary policy tightening cycle evolves. As the services report shows, the CMDI often provides a faster signal of rapidly deteriorating conditions than any of its individual underlying indicators or, indeed, other commonly used indicators of financial distress, such than the VIX.
Nina Boyarchenko is Head of Macrofinancial Studies in the Research and Statistics Group at the Federal Reserve Bank of New York.
Richard K. Crump is a Financial Research Advisor in the Bank’s Research and Statistics group.
Anna Kovner is Director of Financial Stability Policy Research in the Bank’s Research and Statistics Group.
Or Shachar is a Financial Economist in the Bank’s Research and Statistics Group.
How to cite this article:
Nina Boyarchenko, Richard Crump, Anna Kovner and Or Shachar, “How Does the Corporate Bond Market Respond to Financial Market Volatility?” » Federal Reserve Bank of New York Economy of Liberty StreetJune 1, 2022. https://libertystreeteconomics.newyorkfed.org/2022/06/how-is-the-corporate-bond-market-responding-to-financial-market-volatility/
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.