Uncertainty, Credit Spreads, and Investment Dynamics

In the standard bond-pricing framework (e.g., Merton [1974]), the return function of holders of risky corporate debt is a concave function of the firm’s stochastic return, implying that a mean-preserving spread is associated with an increase in the bond risk premium. This feature of the standard debt contract has two important implications for the relationship between uncertainty and investment. First, to the extent that firms face significant frictions in credit markets, the rise in the bond risk premium implies an increase in the cost of capital and hence a reduction in investment; in such environment, uncertainty can have a significant effect on investment dynamics absent any investment irreversibility or managerial risk aversion. Second, if credit market frictions are an important mechanism through which uncertainty affects investment, then the inclusion of the bond risk premium in an empirical investment specification should attenuate the direct impact of uncertainty on investment. Using both the aggregate time-series and firm-level data, we test these two hypotheses and find strong support for the view that the relationship between uncertainty and investment is influenced importantly by the presence of credit market frictions. We then develop a tractable general equilibrium model in which firms issue risky bonds and equity in imperfect capital markets to finance investment projects. We calibrate the uncertainty process using firm-level estimates of shocks to the firms’ profits and show that the model successfully explains the cross-sectional and time-series properties of bond risk premiums and their comovement with uncertainty and aggregate investment. JEL Classification: E22, E32, G31