The effect of interest rate on bond pricing

This thesis investigates the sensitivity of euro-area corporate bond performances to long-term yield shocks, with particular emphasis on the heterogeneity of responses across credit ratings. The empirical analysis focuses on total returns – encompassing both price changes and coupon income – rather than price movements alone. The analysis is motivated by two longstanding anomalies in the literature – the bond yield puzzle and the credit spread puzzle – which highlight the imperfect and asymmetric transmission of interest rate changes to bond markets. By examining the differential effects of yield shocks on investment-grade corporate bonds rated AAA and BBB, the research clarifies the role of credit risk in shaping fixed-income dynamics. The empirical framework combines several econometric methodologies. Vector Autoregressive (VAR), Structural VAR (SVAR), Instrumental-Variables SVAR (SVAR-IV), and Vector Error Correction Models (VECM) are employed to capture short-run adjustments and long-run equilibrium relations. In the SVAR-IV, high-frequency surprises around ECB announcements serve as an external instrument to strengthen shock identification. Findings confirm the canonical inverse relationship between interest rates and bond performance while revealing critical rating-based asymmetries. Contrary to initial expectations, AAA bonds show a more pronounced immediate reaction to yield shocks. Conversely, BBB bonds demonstrate greater vulnerability over the longer horizon, reflecting their higher inherent credit risk and sensitivity to financing conditions. These results indicate that credit quality fundamentally mediates shock transmission, creating a distinct asymmetric impact across the rating spectrum. The main contribution lies in offering a comparative perspective on rating-specific transmission within a euro-area context, where systematic evidence remains scarce compared with U.S. studies. The results shed light on the persistence of the bond yield and credit spread puzzles, suggesting they stem from structural features rather than statistical anomalies. Implications are relevant for policymakers, who must account for transmission heterogeneity, and for investors, for whom return shocks translate into rating-specific differences in performance and risk.