Credit Spreads and Business Cycle Fluctuations

We re-examine the evidence on the relationship between credit spreads and economic activity, by constructing a credit spread index based on an extensive micro-level data set of secondary market prices of outstanding senior unsecured corporate bonds over the 1973–2009 period. Compared with the standard default-risk and other financial indicators, our credit spread index is a robust predictor of economic activity across a variety of economic indicators at both the shortand longer-term forecast horizons. Using an empirical bond-pricing framework, we decompose our credit spread index into a predictable component that captures the available firm-specific information on expected defaults and a residual component—the excess bond premium—which arguably reflects variation in the price of default risk rather than variation in the risk of default. Our results indicate that a substantial portion of the predictive content of credit spreads is due to the excess bond premium. Shocks to the excess bond premium that are orthogonal to the current state of the economy, the Treasury term structure, and stock returns are shown to cause significant declines in consumption, investment, and output as well as in equity prices. Overall, our findings are consistent with the notion that an increase in the excess bond premium reflects a reduction in the risk appetite of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy. JEL Classification: E32, E44, G12