To illustrate the link between bond markets and EPU, we focus on how changes
in European IG non-financial bond yields relate to changes in EPU.
We take the spread to benchmark bond yields to focus on net increases in market
rates. A positive relation between changes in EPU and changes in corporate
bond yields seems evident at first glance; i.e. An increase in EPU goes hand in
hand with an increase in bond yields.
If we take EPU as the single explanatory
variable,8 changes in EPU explain 33% of the variation in corporate bond
returns. This being said, there may be factors affecting EPU and bond yields
simultaneously, such as business cycle effects, which make it difficult to quantify
the magnitude of the transmission.
For example, a recession that leads to
increases in both policy uncertainty and bond yields may exacerbate the
positive relation, if not controlled. What is more, reverse causality, such as
growing EPU pushing corporate bond yields higher and at the same time higher
yields causing more uncertainty and being reflected in the news, is another
Controlling for a set of economic conditions, financial and macro
factors, academic literature provides evidence that EPU positively correlates
with bond risk premia.9 These findings also indicate that negative externality
from EPU to bond markets is economically significant and especially visible for
longer maturity bonds.
All in all, high levels of EPU probably result in a higher
risk premium for bonds, with causality running from EPU to bond markets.