Economists and other analysts look for signs ofthe economy’s current and future performance inmany places, including the bond market. Onerecent signal from that market that may proveuseful involves the spread in the yields betweenjunk bonds and other long-term debt instruments.For example, the Merrill Lynch junk bond indexhas reached its highest level since the last reces-sion, while investment-grade bond yields remainfairly low by historical standards. Junk bonds, orspeculative-grade bonds, are rated below Baa byMoody’s (and below BBB by Standard and Poor’s),the minimum rating for investment-grade bonds.Junk bonds also are called high-yield bonds becausethey carry significantly higher interest rates to com-pensate investors for bearing the higher risk thatis inherent in those bonds. A widening in the spreadbetween junk bonds and other long-term debtinstruments may be a useful signal because junkbonds are issued by firms with marginal creditquality that are more vulnerable to changes ineconomic conditions than investment-grade bor-rowers. This Economic Letter takes a closer lookat the recent increase in junk bond yields, and, inparticular, compares the latest episode to the sharprise in junk bond yields in 1998 following the Asianfinancial crises.

Yield spreads of junk bondsLike any fixed-income securities, the return from hold-ing a junk bond is usually measured by the yield-to-maturity, which is the rate of return for holding abond until maturity. The junk bond yield involvestwo components: the default-free bond yield andthe risk premium. The default-free bond yield refersto the rate of return for holding a similar maturitydefault-free bond, which usually is represented byTreasury securities. The risk premium compensatesthe investor for bearing the credit risk and the liquid-ity risk of the junk bond. Credit risk refers to thepossibility that the borrower will default. Liquidityrisk refers to the potential liquidation cost fromselling the bonds in a thin market. In a thin marketwhere potential buyers are scarce, not only doesthe bid-ask spread on a security widen, but alsosellers must lower the bond price both to lure buy-ers into the market and to compensate them forthe heightened liquidity risk. While the market forTreasury securities is considered very deep andresilient, hence involving little liquidity risk, corpo-rate bonds have liquidity risk because each bond

issue is relatively small. Moreover, each corporatebond has unique attributes, so the number of readybuyers for each bond can be quite limited. Amongcorporate bonds, junk bonds have more liquidityrisk because their issue sizes generally are relativelysmall compared to investment-grade issues. More-over, many institutional investors, including pensionfunds and certain trust accounts, are prohibited frominvesting in below-investment-grade securities, fur-ther limiting the pool of potential investors.

To isolate the junk bond risk premium from pureinterest rate movements, Figure 1 charts the yieldspread between the Merrill Lynch junk bond indexand 7-year constant maturity Treasuries since 1986.Although the available data span only one businesscycle, the figure suggests that the junk bond riskpremium rises and falls with the business cycle. Bor-rowers’ ability to service their debt obligations, partic-ularly marginal borrowers, is usually higher duringeconomic expansions than contractions. So, dur-ing expansions, credit risk tends to be lower and,hence, the yield spread tends to be narrower, whilethe reverse tends to hold during slowdowns. InFigure 1, the yield spread for junk bonds jumped258 basis points from January 1989 to June 1990,just before the economy entered the recession. Thus,the run-up in the junk bond risk premium in 1989

Rising Junk Bond Yields: Liquidity or Credit Concerns?

FRBSF ECONOMIC LETTERNumber 2001-33, November 16, 2001

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Figure 1Spread between junk bond index and 7-year Treasuries

and early 1990 was consistent with the rising creditrisk concerns at that time.

The liquidity shock in 1998Between June 1998 and October 1998, the junkbond risk premium rose 334 basis points, but norecession followed. Rather, the increase in risk spreadsappears to have been tied to turmoil in financialmarkets. Around mid-1997, the Asian financial crisisbegan to unfold, culminating in the Russian govern-ment’s default on its sovereign debt in October 1998.This led to the seizing up of the credit market andthe near collapse of the hedge fund, Long-TermCapital Management. At that time, the large degreeof uncertainty in the credit market made it verydifficult to liquidate risky bonds, as potential investorsexited the corporate bond market in favor of thedefault-free Treasury market. It appeared that the lackof liquidity in the corporate bond market was thedriving force behind the yield rise in 1998.

To see more clearly how a liquidity shock drives junkbond yields, it is useful to look at the comovementin bond yields. The comovement in bond yieldsshould be high in response to a liquidity shock,because it is a systemic event that can be expectedto have a similar qualitative effect (though differentquantitative effect) on corporate bonds across therisk spectrum. In contrast, when changes in bondyields are driven by changes in the credit qualityof the borrowers, the movements in bond yieldswould be expected to respond to the idiosyncraticshock of the borrowers, implying that the comove-ment in bond yields is expected to be lower.

To illustrate this, Figure 2 shows the covariance be-tween the change in Moody’s Aaa rated-Treasuryspread and the change in the junk bond-Trea-sury spread since 1990. During the 1990–1991recession, the comovement in the Aaa-rated andjunk bond yield spreads rose in response to generaldeterioration in the economy, but it took more thana year before the rising covariance peaked. In con-trast, in 1998, the comovement in yield spreadsrose sharply in August and peaked in just threemonths. This suggests that the movement in yieldspreads in 1998 was consistent with a systemic event,namely, the lack of liquidity in the bond market.

Nevertheless, a systemic shock also may worsenthe credit quality of many borrowers, leading to awidespread increase in credit risk premiums andthus a high level of comovement in risk spreads. Todistinguish between liquidity shocks and credit riskshocks further, it may be useful to look at the rela-tion between stock and bond prices. Absent changesin liquidity constraints, movements in bond yieldsreflect the bond market’s assessment of the bor-rower’s creditworthiness. Since many borrowers inthe junk bond market also issue publicly tradedstocks, the stock market also is continuously assess-ing the future prospect of the borrowing firm. Kwan

(1996) shows that there is a strong relation betweenchanges in the bond yield and the borrowing firm’sstock returns, particularly among junk bond bor-rowers, as both stock and bond prices generallyare driven by the same firm-specific information.

In the case of a general liquidity shock, however,movement in risk spreads may be less tightly linkedwith firm-specific developments, as evidenced dur-ing the 1998 financial market turmoil. For example,consider the performance in four sectors: telecom-munications, technology, energy, and health care.Between November 1997 and October 1998, therisk spread for junk bonds in telecom, technology,and health care sectors rose between 100% and130%. Despite the similarity in the changes in bondyields, the stock price performance for these threesectors was quite different. The average annualizedstock returns for junk bond issuers in telecom andtechnology were positive, at 17.8% and 131%,respectively, while those in health care were neg-ative, at –55%. The energy sector saw the largestrelative rise in junk bond spreads, at 233%, eventhough the issuers’ average stock return, at –30.5%,was higher than those in the health care sector.

The apparent disconnect between the pricing ofthe debt and equity of junk bond issuers during1997–1998 suggests that the rise in junk bond riskspreads was not entirely driven by changes in firm-specific fundamentals. Rather, it was more con-sistent with a general shift in liquidity preferenceamong investors.

Putting recent movements into perspectiveBefore the terrorist attacks on September 11, the yieldspread of the Merrill Lynch junk bond index hadrisen more than 300 basis points since the beginningof 2000 (Figure 1). This was accompanied by agradual increase in the comovement of bond yield

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Figure 2Comovement in bond yield spreads

spreads. These patterns seem to suggest that beforethe attacks, the run-up in junk bond spreads wasdriven by concerns about rising credit risk. However,following the attacks, the spread skyrocketed almost200 basis points to 968 basis points, just 46 basispoints shy of the peak recorded during the 1990–1991recession. While there is no question that a largepart of the rise in junk bond yields reflects investors’reassessment of credit risk, the comovement in bondyield spreads, shown in Figure 2, shot up to a levelnot seen before. Both the rate of the increase andthe level of comovement in yield spreads afterSeptember 11 indicate that some of the sizablejump in yield spreads may be attributable to thelimited liquidity in the junk bond market.

Of the four sectors examined earlier, between January2000 and August 2001, junk bond spreads in theenergy sector had risen only 21% (or 100 basispoints) while spreads in the health care sector hadactually declined 15% (or 56 basis points). Thisreflects the positive developments in these two sec-tors, as evidenced by the 48% one-year return onenergy stocks and the 70.5% return on the healthcare stocks of the junk bond borrowers. During thattime, junk bond investors clearly were discriminat-ing between good and poor performers as judgedby the stock market. The junk bond spread rose225% (1129 basis points) in the telecom sector and116% (553 basis points) in the technology sector.The one-year stock returns of the junk bond borrow-ers in the telecom sector and the technology sectorwere –57.4% and –72.5%, respectively. This furthersuggests that the increase in junk bond yields beforethe attacks was driven by credit concerns aboutspecific companies, most notably telecom firmsand technology companies.

After the terrorist attacks, the widening of risk spreadson junk bonds was evident in most sectors, but espe-cially among firms in the air travel and tourism indus-tries. Figure 3 shows changes in risk spreads basedon Merrill Lynch’s index for firms in 16 sectors withjunk bonds outstanding, from September 10 to Oc-tober 10, 2001. While investors are reassessing thecredit risk of different borrowers in different sectors asa result of the attacks, the fact that all sectors amongjunk bond issuers show some increase in risk spreadssuggests that a deterioration of liquidity in the junkbond market may have exacerbated borrowing costs.

ConclusionJunk bonds provide financial market signals aboutcurrent and future economic activity because their

yields reflect the market’s assessment of the creditprospects of the borrowing firms, whose marginalcredit quality is highly sensitive to changing eco-nomic conditions. However, in addition to creditconcerns, junk bond yields also are driven by sys-temic factors, among which the level of liquidityin the bond market is perhaps the most important.In interpreting junk bond yields, it is necessary toseparate the systemic factors from the idiosyncraticfactors. Before September 11, the run-up in junkbond yields in 2001 seems to have reflected specificcredit concerns about the borrowing firms, as firmswhose stocks were performing well generally did notsee their junk bond yields go up, and the comove-ment in bond yields was not that high. After Sep-tember 11, the sharp rise in junk bond yields clearlyreflects the heightened credit risk of the borrowers.At the same time, the comovement in bond yieldsspiked up to a level not seen before, suggesting thatdeteriorating liquidity in the junk bond market mayhave pushed borrowing costs up further.

Simon KwanResearch Advisor

Reference

Kwan, S.H. 1996. “Firm-specific Information and theCorrelation between Individual Stocks and Bonds.” Journal of Financial Economics 40, pp. 63–80.

Opinions expressed in the Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bankof San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Judith Goff, with theassistance of Anita Todd. Permission to reprint portions of articles or whole articles must be obtained in writing. Permission tophotocopy is unrestricted. Please send editorial comments and requests for subscriptions, back copies, address changes, andreprint permission to: Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, CA94120, phone (415) 974-2163, fax (415) 974-3341, e-mail Pubs.sf@sf.frb.org. The Economic Letter and other publications andinformation are available on our website, http://www.frbsf.org.

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Figure 3Changes in junk bond yield spreads by industry(9/10/01–10/10/01)

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