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This article was published by Investcorp and is reprinted here with permission.

Executive Summary

This paper analyzes correlations between credit spreads and interest rates across various sectors and credit ratings in the US. Our work was prompted by chairman Bernanke’s announcement this summer of possible tapering of the ongoing quantitative easing program which marked a turning point for interest rates from their historically low levels. We analyze data from 1990 to the present and use a statistically robust multi-factor risk model framework which can be calibrated to draw both long-term and short-terms conclusions. Our findings are relevant for credit portfolio managers contemplating the impact of rising interest rates and steepening Treasury curve on corporate bond portfolios.

Consistent with our earlier studies, we find strong negative correlation between sector spreads and rate shifts and twists. A uniform increase in rates is associated with tighter credit spreads, while a uniform drop in rates leads to wider spreads. In most industries, with the exception of the banking and brokerage and the consumer sector, lower credit quality is associated with stronger negative correlation.

We compare our current estimates with the results of a similar analysis we conducted in 2003 and find many similarities but also some notable differences. The long-term models estimated currently and 10 years ago show similar patterns. However, the short-term versions are quite different. The short-term correlation estimates in 2013 are much weaker than those from 2003 – likely a result of the Fed’s ongoing quantitative easing program which has weakened the normal relationships between the economic recovery (represented by spreads) and monetary policy (represented by rates). Moreover, correlation patterns in the banking and brokerage sector have changed prior and post the financial crisis. These results have important implications for risk management as well as for identifying relative value opportunities across sectors with different
rate sensitivities.

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