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This analysis extends the findings of previous researchers by examining the relationship between Federal Reserve monetary policy and long-term returns to various sectors of the U.S. corporate and governmental bond markets. The results of this analysis show that corporate bond market return patterns are strongly associated with Federal Reserve monetary policy periods. Specifically, bond market indexes exhibit higher returns and lower standard deviations of returns during expansive monetary policy environments. In fact, all of the corporate bond indexes analyzed in this study exhibited negative Sharpe ratios during restrictive monetary policy environments. This would indicate that investors would be better off by investing in T-bills rather than corporate bonds during restrictive monetary policy environments. At minimum, the results suggest that investors in the corporate bond market should closely monitor Federal Reserve monetary policy.

Market participants closely scrutinize Federal Reserve monetary policy. Announcements (and non-announcements) of modifications to existing monetary policy receive considerable attention in the financial press and national media. Markets seemingly rise and fall in reaction to formal Fed announcements and to the carefully chosen words of Federal Reserve chairman Alan Greenspan (e.g., Wessel & Schlesinger, 1998). Academic researchers have also established the relevance of monetary policy announcements by documenting a prominent “announcement effect” associated with Fed announcements.4 Several researchers have extended this research and show that monetary policy announcements are also associated with subsequent long-term security return patterns (e.g., Jensen, Mercer, & Johnson, 1996; Thorbecke, 1997; Patelis, 1997). The purpose of this analysis is to extend the findings of earlier researchers by examining the relationship between Federal Reserve monetary policy and long-term returns to various sectors of the U.S. corporate and government bond markets. Jensen et al. (1996) show that the default and term premiums are significantly related to prior announcements of changes in monetary policy. This evidence indicates that the fixed income return patterns identified in past research may differ based on the default risk of the underlying security and its maturity structure. This issue has important ramifications for fixed income investors since it suggests that monetary policy changes should be considered when choosing the default and maturity structure of a fixed income portfolio. We examine returns using 30 alternative fixed income indexes developed by Lehman Brothers. The findings indicate that the monetary-policy-related return patterns that have been identified by previous researchers differ based on the credit risk and maturity structure of the underlying instrument. This evidence supports the view that monetary policy should play a prominent role in determining the credit risk and maturity structure of a fixed income portfolio. The remainder of this study is organized as follows: Section 2 presents a basic model that considers the relationship between monetary policy developments and security returns; Section 3 reviews the literature on the influence of monetary policy on security returns; Section 4 details the characterization of the monetary environment; Section 5 describes the methodology of the study and data employed; Section 6 reviews the results of our analysis; and Section 7 concludes the paper.

The results of this analysis show that bond market return patterns are strongly associated with Federal Reserve monetary policy. Specifically, bond market indexes exhibit higher returns and lower standard deviations of returns during expansive monetary policy environments relative to restrictive environments. This finding is consistent with previous evidence that shows comparable patterns existence in both stock and bond returns. Our contribution to this research is to show that the performance patterns differ across bonds based on both their credit quality and time to maturity. Specifically, the patterns are most pronounced for bonds with higher credit risk and longer times to maturity. This finding supports the contention that monetary policy developments are associated with subsequent changes in investor inflation expectations and the risk premiums required by investors. This is further support for the contention that monetary policy should be considered as a factor in future asset-pricing models. The prominence of the bond return patterns is established by the observation that all of the corporate bond indexes exhibit negative Sharpe ratios during restrictive monetary policy environments, while during expansive periods they are all positive and relatively large. This indicates that investors could have achieved superior performance by investing in T-bills rather than corporate bonds during restrictive monetary policy environments. The practical consequences of our findings for the fixed income portfolio manager are that monetary policy developments should be incorporated into decisions about the credit quality and maturity structure of the portfolio. During expansive monetary policy periods, long-term bonds of lower credit quality achieved the highest returns. In contrast, during restrictive monetary environments, short-term bonds of high credit quality provided the highest returns. Over the period studied, a sector rotation or tactical asset allocation strategy based on these findings would have added considerable value to a portfolio.