Relationship between BBB credit spreads and rising interest rates

Question

A stylized fact in markets seems to be that there is a negative correlation between interest rates and corporate spreads - as interest rates rise, spreads tend to tighten and vice versa.

I'm wondering if this relationship depends on the macroeconomic backdrop behind rising rates. In addition to interest rates, credit spreads are also influenced by expected inflation, and the level of growth.

As an example, in an environment where rates are rising due to inflation caused by strong growth and a robust economy, it would make sense for credit spreads to tighten. However, if rates are rising in response to a stagflation scenario (low growth but high inflation), would credit spreads be expected to widen due to weak growth, and higher uncertainty/risk of defaults? Does the growth component matter, or are rising rates + rising inflation generally sufficient to tighten spreads?

Answer 1

One explanation might be purely quantitative: The spread is to compensate for the present value (cost) of a possible future default. When interest rates rise all else equal, the discounted cost of future default decreases, which translates into tighter spreads. See for instance Leland(1994b) as presented here.

As investigated in a paper from Kansas Fed here, the effect you are referring to do seem to exist in the short run, even though they are reversed in the longer run.

Answer 2

When interest rates rise, it is often because a rise of the inflation (for instance with the ECB and the FED). So it means that the nominal debt value of a company decreases and/or that the company will have higher nominal cash flow. To conclude : the credit risk is lower. So, the spread is lower. Growth is linked to cash flow. In fact you are expecting cash flow to increase at the rate of the growth + the inflation. So if grow is higher than expected, the company will have stronger cash flow and a reduced credit risk.

This is a very simple and intuitive answer. I hope I have helped.