European Central Bank working paper revisits excess bond premium and finds tighter policy raises default risk compensation more for cyclical firms

The European Central Bank published Working Paper No 3118 (authored by Mar Domenech Palacios and not representing ECB views) assessing whether firm-specific cyclical and idiosyncratic risk profiles change how corporate bond spreads respond to monetary policy. Extending the excess bond premium (EBP) framework to let default-risk compensation vary with firm risk characteristics, the paper finds that a larger share of spread widening after a tightening shock reflects higher default-risk compensation than suggested by the traditional EBP decomposition, with the effect concentrated in firms with more cyclical risk. The analysis combines weekly option-adjusted spreads on US non-financial corporate bonds since 2016 with firm-level equity data and high-frequency monetary policy surprises around Federal Reserve announcements. A tightening surprise calibrated to a 25 basis point increase in the one-year Treasury bill is associated with an almost 10 basis point rise in corporate spreads within the weekly window, with most of the average response still attributed to the EBP but a larger fraction shifting to default-risk compensation under the augmented model. For firms with higher cyclicality, the additional spread widening following a contractionary shock is partly fundamentals-driven, with up to about one quarter attributed to higher default-risk compensation (versus roughly 8% under the traditional EBP), while firms with high idiosyncratic risk show no strong differential response to monetary policy shocks relative to other firms.