Credit spreads on sterling corporate bonds and the term structure of UK interest rates

In this paper the relationship between credit spreads on sterling corporate bonds and the term structure of UK interest rates is explored. In particular, the question of whether credit spreads are a reliable indicator of corporate bond default risk is examined. Using daily price quotes from 1990 to 1998, a small negative relationship is identified between credit spreads on sterling investment-grade corporate bonds and the level and slope of the term structure of UK interest rates. The results are weaker than those found by some previous studies which examined the relationship between US corporate bond credit spreads and the term structure of US interest rates. The weakness of the relationship suggests that credit spreads on sterling investment-grade corporate bonds have been driven by factors other than default risk. If so, we should be cautious in interpreting such credit spreads as measures of bond default risk. This result is important to both those in the field of financial stability interested in leading indicators of corporate defaults, and to monetary policy makers interested in the impact of interest rate changes on corporate bond default risk. Similar work should be repeated for sterling sub investment-grade corporate bonds once a sufficiently large data set can be assembled.