Credit Quality Spreads, Bond Market Efficiency and Financial Fragility

Abstract

The current usefulness in U.K. monetary policy formulation of corporate-government bond yield differentials is assessed. A large U.S. literature stresses a direct link with expected default risk and, hence, the economic cycle but also notes that such a relationship may be distorted by variations in market segmentation or liquidity. The econometric results show a deterioration in U.K. market performance over time, which may be related to changes in liquidity and market segmentation. These imply that spreads may not be a useful monetary indicator and that risk may be inaccurately priced in the U.K. domestic bond markets. Copyright 1992 by Blackwell Publishers Ltd and The Victoria University of Manchester