Abstract: This paper explores the eiect of equity volatility on corporate bond yields. Panel data for the late 1990s show that idiosyncratic ¢rm-level volatility can explain as much cross-sectional variation in yields as can credit ratings. This ¢nding, together with the upward trend in idiosyncratic equity volatility documented by Campbell, Lettau, Malkiel, and Xu (2001), helps to explain recent increases in corporate bond yields. DURING THE LATE 1990s, THE U.S. EQUITY and corporate bond markets behaved very diierently. As displayed in Figure 1, stock prices rose strongly, while at the same time, corporate bonds performed poorly. The proximate cause of the low returns on corporate bonds was a tendency for the yields on both seasoned and newly issued corporate bonds to increase relative to the yields of U.S.Treasury securities. These increases in corporate^Treasury yield spreads are striking because they occurred at a time when stock prices were rising; the optimism of stock market investors did not seem to be shared by investors in the corporate bond market. There are several reasons why the prices of corporate bonds might diverge from the prices of corporate equities. First, stock prices will increase if investors become more optimistic about future corporate pro¢ts. Optimistic expectations bene¢t stock prices much more than bond prices, since stockholders receive all residual pro¢ts, while corporate bondholders receive no more than the promised payments of principal and interest. This explanation does not account for the behavior of corporate bond yields in the late 1990s, however, because yield spreads on corporate bonds over Treasuries should fall, not rise, if investors become optimistic about corporate pro¢ts and thus reduce their expected probabilities of default. Second, there might be a composition eiect if corporate bonds are issued by diierent companies than those that dominate value-weighted equity indexes. Third, an increase in the liquidity premium on corporate bonds relative to Treasury bonds might drive down corporate bond prices without any eiect on equity prices. Fourth, the yields on newly issued corporate bonds might vary because of changes in the special features of these bonds, for example, an increase in the value of call provisions. Such an increase would drive down the prices and drive

Abstract: This article provides evidence linking corporate governance mechanisms to higher bond ratings and lower bond yields. Governance mechanisms can reduce default risk by mitigating agency costs and monitoring managerial performance and by reducing information asymmetry between the firm and the lenders. We find firms that have greater institutional ownership and stronger outside control of the board enjoy lower bond yields and higher ratings on their new bond issues. However, concentrated institutional ownership has an adverse effect on yields and ratings. These results are robust to a specification that controls for institutional ownership being influenced by bond yields.

Abstract: Government bond spreads We provide evidence that the movements in yield differentials between euro zone government bonds explained by changes in international risk factors – as measured by banking and corporate risk premiums in the United States – are more pronounced for bonds issued by Italy and Spain. Liquidity factors play a smaller role, so policies meant to increase financial market efficiency do not appear sufficient to deliver a ‘seamless’ bond market in the euro area. The risk of default is a small but important component of yield differentials movements, which signal market perceptions of fiscal vulnerability, impose market discipline on national fiscal policies, and may be reduced only by further convergence in debt ratios. — Lorenzo Codogno, Carlo Favero and Alessandro Missale

Abstract: We construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring, and allows for compensation for illiquidity. Using a new and relatively efficient method, we estimate the model using Russian dollar-denominated bonds. We consider the determinants of the Russian yield spread, the yield differential across different Russian bonds, and the implications for market integration, relative liquidity, relative expected recovery rates, and implied expectations of different default scenarios. THIS PAPER DEVELOPS A MODEL of the termstructure of credit spreads on sovereign bonds that accommodates: (i) Default or repudiation: The sovereign announces that it will stop making payments on its debt; (ii) Restructuring or renegotiation: The sovereign and the lenders ‘‘agree’’ to reduce (or postpone) the remaining payments; and (iii) A‘‘regime switch,’’ such as a change of government or the default of another sovereign bond that changes the perceived risk of future defaults.We build on the framework of Duffie and Singleton (1999), showing that cash flows promised by a sovereign bond can be discounted using a default-adjusted short-termdiscount rate that reflects the m ean arrival rate, and associated losses in market value upon arrival, of each of the aforementioned types of credit events. Since a sovereign credit event is often not a ‘‘liquidation event,’’ the model allows for continued trading (and pricing) of a sovereign instrument through credit events, possibly after writedowns in face value or cash distributions to creditors on credit event dates. Additionally, we accommodate the possibility that bonds issued by the same sovereign, of exactly the same type but possibly of different maturities, may be priced in the market using different discount factors. Reasons for this may include: (i) Bond covenants may not include cross-default clauses that would force, upon the default of one bond, the simultaneous default of other bonds of the same type, but of a different maturity. For various strategic reasons related to internal

Abstract: This chapter reviews the behavior of financial asset prices in relation to consumption. The chapter lists some important stylized facts that characterize US data, and relates them to recent developmenets in equilibrium asset pricing theory. Data from other countries are examined to see which features of the US experience apply more generally. The chapter argues that to make sense of asset market behavior one needs a model in which the market price of risk is high, time-varying, and correlated with the state of the economy. Models that have this feature, including models with habit-formation in utility, heterogeneous investors, and irrational expectations, are discussed. The main focus is on stock returns and short-term real interest rates, but bond returns are also considered.

Abstract: Prior research has documented positive abnormal stock returns around the announcements of repurchase programs; several explanations of these returns have been suggested, including signaling, free cash flow, and wealth redistributions. This study analyzes abnormal stock, bond, and firm returns around repurchase announcements to examine these hypotheses. We find evidence consistent with both signaling and wealth redistribution. The loss to bondholders is a function of the size of the repurchase, and the risk of the firm's debt. We also find that bond ratings are twice as likely to be downgraded as upgraded after the announcement of the repurchase program. IN THIS PAPER, WE EXAMINE the impact of open market share repurchase announcements on both stock and bond prices. Positive stock price reactions to the announcement of an open market repurchase program are well documented in the empirical finance literature.1 Several potential explanations of the positive stock returns have been posited in the literature, including signaling, free cash flow, and bondholder wealth expropriation. However, only the signaling and wealth transfer or wealth expropriation hypotheses have implications for the impact of a repurchase program on both stock and bond returns. The signaling hypothesis suggests that bond and stock returns should be positively correlated; the signal provides information regarding the firm as a whole and, consequently, bond and stock prices will move in the same direction depending on the signal.2 Alternatively, the wealth transfer hypothesis suggests that bond and stock value changes should be negatively correlated. Ignoring any dead-weight losses (transactions costs), a wealth transfer is a zero-sum game; any gains to shareholders must come at the expense of bondholders and vice versa.

Abstract: This paper investigates the empirical determinants of emerging market sovereign bond spreads, using a ragged-edge panel of JP Morgan EMBI and EMBI Global secondary market spreads and a set of common macro-prudential indicators. The panel is estimated using the pooled mean group technique due to Pesaran, Shin and Smith (1999). This is essentially a dynamic error correction model where cross-sectional coefficients are allowed to vary in the short run but are required to be homogeneous in the long run. This allows a separation of short-run dynamics and adjustment towards the equilibrium. The model is used to benchmark market spreads and assess whether sovereign risk was 'overpriced' or 'underpriced' during different periods over the past decade. The results suggest that a debtor country's fundamentals and external liquidity conditions are important determinants of market spreads. However, the diagnostic statistics also indicate that the market assessment of a country's creditworthiness is more broad based than that provided by the set of fundamentals included in the model. We also find that the generalised fall in sovereign spreads seen between 1995 and 1997 cannot be entirely explained in terms of improved fundamentals.

Abstract: This article studies how collateral affects bond yields. Using a large data set of public bonds, we document that collateralized debt has higher yield than general debt, after controlling for credit rating. Our model of agency problems between managers and claim holders explains this puzzling result by recognizing imperfections in the rating process. We test the model’s implications. Consistent with our model and in results new to the literature, we find the yield differential between secured and unsecured debt, after controlling for credit rating, is larger for low credit rating, nonmortgage assets, longer maturity, and with proxies for lower levels of monitoring.

Abstract: This paper examines the link between REIT, financial asset and real estate returns, and tests whether it changed subsequent to the “REIT boom” of the early 1990s. The main focus is on answering the question do REIT returns now better reflect the performance of underlying direct (unsecuritized) real estate? We develop and implement a variance decomposition for REIT returns that separates REIT return variability into components directly related to major stock, bond, and real estate-related return indices, as well as idiosyncratic or sector-specific effects. This is applied to aggregate REIT sector (NAREIT) returns as well as returns to size and property-type based REIT portfolios. Our results show that the REIT market went from being driven largely by the same economic factors that drive large cap stocks through the 1970s and 1980s to being more strongly related to both small cap stock and real estate-related factors in the 1990s. There is also a steady increase over time in the proportion of volatility not accounted for by stock, bond or real estate related factors. We also find that small cap REITs are “more like real estate” compared to larger cap REITs, at least over the 1993–1998 period. We argue that this could be a result of the institutionalization of the ownership of larger cap REITs that took place in the 1990s.

Abstract: The correlation between stock market and government bond returns was positive through most of the 1900s, but negative in the early 1930s, the late 1950s, and recently. If the trend is sustained, the shift to a negative correlation should boost government bond valuations owing to bonds9 attractive hedging characteristics. This exploration of sources of stock-bond correlation examines asset class behavior in different economic conditions. Growth and volatility shocks tend to push stocks and bonds in opposite directions, while inflation shocks tend to cause common discount rate variation across asset classes. The latter effect dominated in the variable inflation levels of 1960–1990 and kept stock-bond correlations positive. As long as inflation rates remain low, low correlations should prevail. Correlations become even more negative during deflationary recessions, equity weakness, and high-volatility flight to quality periods.

Abstract: Prior research has documented positive abnormal stock returns around the announcements of repurchase programs; several explanations of these returns have been suggested, including signaling, free cash flow, and wealth redistributions. This study analyzes abnormal stock, bond, and firm returns around repurchase announcements to examine these hypotheses. We find evidence consistent with both signaling and wealth redistribution. The loss to bondholders is a function of the size of the repurchase, and the risk of the firm's debt. We also find that bond ratings are twice as likely to be downgraded as upgraded after the announcement of the repurchase program.

Abstract: Theory predicts that the quality of a firm's information disclosure can affect the term structure of its corporate bond yield spreads. Using cross-sectional regression and Nelson-Siegel yield curve estimation, I find that firms with higher AIMR disclosure rankings tend to have lower credit spreads. Moreover, this ``transparency spread'' is especially large among short-term bonds. These findings are consistent with the theory of discretionary disclosure as well as the incomplete accounting information model of Duffie and Lando (2001). The presence of a sizable short-term transparency spread can attenuate some of the empirical problems associated with structural credit risk models.

Abstract: We analyze volatility spillover from the US and aggregate European bond markets into individual European bond markets using a GARCH volatility-spillover model. We find strong statistical evidence of volatility-spillover e ffects from both the US and Europe into the individual bond markets.For the EMU countries,the US volatility-spillover effects are rather weak whereas the European volatility-spillover effects are strong.The opposite applies to the non-EMU countries.Pure local volatility e ffects are substantial. The introduction of the euro has strengthened the European volatility-spillover effects for the EMU countries.The non-EMU countries are unaffected hereby.

Abstract: The “Fed model” is a popular yardstick for judging whether the stock market is fairly valued. It compares the stock market9s earnings yield to the long-term government bond yield, while more traditional methods evaluate stock market valuation without regard to the level of interest rates. The Fed model is theoretically flawed, as it compares a real number to a nominal number, ignoring the fact that over the long term nominal earnings generally move in tandem with inflation. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed model fails this test?traditional methods ace it. Lack of predictive ability aside, investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower. This does not imply that the Fed model is valid, rather only that investors have historically followed it, perhaps in error. The relationship of stock and bond market yields is more complicated than conceived by the Fed model, varying systematically with perceptions of long-term stock and bond market risk. Addition of risk to the Fed model solves the puzzle of why stocks outperformed bonds for the first half of the 20th century, but have underperformed bonds since.

Abstract: This paper presents the first comprehensive test of whether well-known conflicts of interest at bond rating agencies importantly influence their actions. This hypothesis is tested against the alternative that rating agency actions are primarily influenced by a countervailing incentive to protect their reputations as delegated monitors. These two hypotheses generate a number of testable predictions regarding the anticipation of credit-rating downgrades by the bond market, which we investigate using a new data set of about 2,000 credit rating migrations from Moody's and Standard & Poor's, and matching issuer-level bond prices. The findings strongly indicate that rating changes do not appear to be importantly influenced by rating agency conflicts of interest but, rather, suggest that rating agencies are motivated primarily by reputation-related incentives.

Abstract: When a bank grants a loan, it takes the risk that the borrower will not honor his debt. To reduce this uncertainty, banks have created instrumental evaluation methods in order to try to evaluate the risk more objectively. An analysis of financial counselors’ practices shows the limits of these methods. To obtain information needed for the financial risk evaluation and to reduce the information asymmetry between bankers and borrowers, financial counselors integrate social networks to establish bonds of trust and to accumulate social capital. The quality of the social bond determines the quality of the gathered information and therefore the quality of the risk evaluation. Bank management is aware of the limits of instrumental methods and the importance of social risk evaluation. To improve their economic efficiency, they modify their work organization and their management practices so as to facilitate the emergence of a bond of trust and the accumulation of social capital by their financial counselors. The analysis of economic actors’ speech and behavior involved in activities of credit shows that behind the claimed altruism nature of the trust relationship exists an economic rationality whose social and temporal horizons of optimization differ from the model of the trade exchange seen in conventional economic theory.

Abstract: This paper presents the case for and the evidence in favour of passive investment strategies and examines the major criticisms of the technique. I conclude that the evidence strongly supports passive investment management in all markets— smallcapitalisation stocks as well as large-capitalisation equities, US markets as well as international markets, and bonds as well as stocks. Recent attacks on the efficient market hypothesis do not weaken the case for indexing.

Abstract: This paper presents the case for and the evidence in favour of passive investment strategies and examines the major criticisms of the technique. I conclude that the evidence strongly supports passive investment management in all markets - small-capitalisation stocks as well as large-capitalisation equities, US markets as well as international markets, and bonds as well as stocks. Recent attacks on the efficient market hypothesis do not weaken the case for indexing.

Abstract: This chapter reviews the behavior of financial asset prices in relation to consumption. The chapter lists some important stylized facts that characterize U.S. data, and relates them to recent developments in equilibrium asset pricing theory. Data from other countries are examined to see which features of the U.S. experience apply more generally. The chapter argues that to make sense of asset market behavior one needs a model in which the market price of risk is high, time-varying, and correlated with the state of the economy. Models that have this feature, including models with habit-formation in utility, heterogeneous investors, and irrational expectations, are discussed. The main focus is on stock returns and short-term real interest rates, but bond returns are also considered.

Abstract: This article develops a contingent claim model to price a default-risky, catastrophe-linked bond. This model incorporates stochastic interest rates and more generic loss processes and allows for practical considerations of moral hazard, basis risk, and default risk. The authors compute default-free and default-risky CAT bond prices by using the Monte Carlo method. The results show that both moral hazard and basis risk drive down the bond prices substantially; these effects should not be ignored in pricing the CAT bonds. The authors also show how the bond prices are related to catastrophe occurrence intensity, loss volatility, trigger level, the issuing firm's capital position, debt structure, and interest rate uncertainty.

Abstract: Why are spreads on corporate bonds much wider than would be implied by expected losses from default? Previous explanations of this puzzle have assumed that investors can diversify away the risk that actual losses in a corporate bond portfolio will exceed expected losses. However, the skewness in the distribution of corporate bond returns implies that achieving such diversification will require an extraordinarily large portfolio. We present evidence from the market for collateralised debt obligations suggesting that such large portfolios are unattainable. Hence, investors always face the risk that actual losses will exceed expectations. Credit spreads are so wide because they compensate investors for such risk.

Abstract: Recent evidence indicates that using multiple forward rates sharply predicts future excess returns on U.S. Treasury Bonds, with the R2's being around 30%. The projection coefficients in these regressions exhibit a distinct pattern that relates to the maturity of the forward rate. These dimensions of the data, in conjunction with the transition dynamics of bond yields, offer a serious challenge to term structure models. In this article we show that a regime-shifting term structure model can empirically account for these challenging data features. Alternative models, such as affine specification, fail to account for these important features. We find that regimes in the model are intimately related to bond risk premia and real business cycles.

Abstract: This paper investigates the presence of asymmetric conditional second moments in international equity and bond returns. The analysis is carried out through an asymmetric version of the Dynamic Conditional Correlation model of Engle (2002). Widespread evidence is found that national equity index return series show strong asymmetries in conditional volatility, while little evidence is seen that bond index returns exhibit this behaviour. However, both bonds and equities exhibit asymmetry in conditional correlation. Worldwide linkages in the dynamics of volatility and correlation are examined. It is also found that beginning in January 1999, with the introduction of the Euro, there is significant evidence of a structural break in correlation, although not in volatility. The introduction of a fixed exchange rate regime leads to near perfect correlation among bond returns within EMU countries. However, equity return correlation both within and outside the EMU also increases after January 1999. JEL Classification: F3, G1, C5

Abstract: Previous studies find that the interest rate term spread predicts real US economic activity We show that this relationship breaks down for the 1990s and suggest that its earlier success was due to high and volatile inflation We find, however, that the high-yield spread (HYS) between "junk bond" and government bond yields predicts real activity during the 1990s--especially high levels of the HYS We also find that the HYS works through both the demand and the supply side of the economy We interpret our findings as supportive of a financial accelerator mechanism Copyright 2003, International Monetary Fund

Abstract: We examine various dynamic term structure models for monthly US Treasury yields from 1964 to 2001. Of particular interest is the predictability of bond excess returns. Recent evidence indicates that using multiple forward rates can sharply predict future excess returns on bonds; the R2 of this predictability regression can be as high as 30%. In addition, the projection coefficients in these predictability regressions exhibit a tent shaped pattern that relates to the maturity of the forward rate. This dimension of the data in conjunction with the transition dynamics of bond yields (i.e., conditional volatility and cross-correlation of bond yields) poses an serious challenge to term structure models. In this paper we present and estimate a regime-shifts term structure model, and our findings show that this model can account for all aspects of the predictability regression and the transition dynamics of yields. Alternative models, such as affine factor models, cannot account for these features of the data. We find that the regimes in the model are related to the NBER business-cycle indicator.