Paper finds key relationship between interest rate actions, corporate credit risk as measured by CDS

A positive, significant relationship exists between monetary policy shocks (such as those resulting from announcements by the Federal Reserve’s rate-setting committee) and corporate credit risk as measured by credit default swaps (CDS) over the last two decades, according to a new paper published last week.

The paper – “Credit Risk and the Transmission of Interest Rate Shocks,” which analyzes the relationship between unexpected movements in monetary policy and corporate credit risks, measured by CDS – was released Dec. 3 by the Treasury’s Office of Financial Research (OFR). The agency said that, more precisely, the paper found significant diversity in the sensitivities of firm-level credit risk and equity price responses to monetary policy. Those responses are to actions taken by the Fed’s Federal Open Market Committee (FOMC).

“Firms that are ex-ante riskier, given by higher historical CDS, higher leverage, or lower market size, display greater sensitivities,” OFR said of the study results. “Among the three, CDS seems to play the most prominent role in the transmission of monetary policy.”

A CDS is a type of insurance policy where the issuer of a bond insures the buyer’s potential losses as part of the agreement.

The paper also asserts that such dynamics were “prominently displayed” surrounding major policy actions in March 2020, in response to the financial turbulence related to the coronavirus crisis.

Credit Risk and the Transmission of Interest Rate Shocks