Credit Risk and the Macroeconomy

We construct a new credit spread index, employing an extensive micro-level data set of secondary market prices of outstanding senior unsecured bonds over the 1973– 2009 period. Compared with the standard default-risk indicators such as the Baa-Aaa corporate bond spread and the paper-bill spread, our credit spread index is a robust predictor of future economic activity across a variety of economic indicators, sample periods, and forecast horizons. Using a flexible empirical bond-pricing framework, we decompose our credit spread index into a predictable component that captures the available firm-specific information on default risk and a residual component—the so-called excess bond premium. The results indicate that a substantial portion of the predictive content of our credit spread index for economic activity is attributable to the excess bond premium. Indeed, in the post-1985 period, the excess bond premium accounts for all of the predictive content of our credit spread index. Shocks to the excess bond premium that are orthogonal to current economic activity, the information contained in the term structure of interest rates, and news embedded in the stock market returns are shown to cause economically and statistically significant declines in consumption, investment, and output. 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, which has significant adverse consequences for economic outcomes. JEL Classification: E32, E44, G28