An Empirical Study on Impact of Changes in Macro Economic Variables on Bond Yield Curve - Evidence from Indian Corporate Bond Market

Abstract

A well developed corporate bond market provides an alternative source of finance for firms and better yield for investors. It facilitates for economic development through channelization of savings into investments. Investments in bonds are not risk free. Bond yields are largely affected by changes in inflation and interest rates. In this study, selected corporate bonds are considered and aimed at analyzing the determinants of the yield curve by looking, how yield curve responds to a given change in macroeconomic variable. To test the impact, macroeconomic variables such as interest rate and inflation rate has been taken with latent factor such as slope, curvature and level (Short term, Medium term and long term interest rate). Latent factor has been derived from Nelson Siegel Model where slope = [(y_t (3)-( y_t (120)], Curvature= [2*( y_t (48)-( y_t (31))-( y_t (120)), Level= y_t (120)]. Data set of three years from 2012 to 2014 has been taken and the same data has been used for vector error correction model for an in-depth analysis. In order to run Vector Error Correction Model, Augmented Dickey fuller test has been used to check stationarity of the data. Johansen co-integration test is used to check the level at which variables are co-integrated and also to understand long run relationship of the variables. Impulse response functions have also been used to understand macroeconomic shock on latent variables, finally the results concluded that inflation rate shock affects positively to the inflation rate and interest rate shock affects negatively to the interest rate. Increase in inflation rate tends to decrease in one of the component of yield curve (i.e., level) which deters the investors from investing in bonds. Decrease in interest rate attracts to investors to purchase the bonds and when there is increase in interest rate investors usually sell bonds.

Keywords: Yield curve, Vector Error Correction Model, Inflation, Interest rate