Unemployment and Credit Risk

Corporate bond yields are sensitive to labor market conditions. During the 1929-2015 period, a one percentage point increase in the unemployment rate is associated with a widening of the Baa-Aaa credit spread by 13 basis points. This paper explores the impact of labor market conditions on credit risk, by incorporating defaultable debt into an otherwise standard Diamond-MortensenPissarides labor search framework. A reasonably calibrated model quantitatively accounts for the strong response of credit spreads to unemployment, in addition to other salient features of credit spreads. In the model, the possibility of default renders corporate bond prices (and credit spreads) sensitive to the variation in the asset value of employment relationships, driven by labor market conditions. ∗Fisher College of Business, The Ohio State University, 2100 Neil Avenue, Columbus OH 43210. Tel: (510)-725-8868, and e-mail: [email protected]. †I thank my dissertation committee, Kewei Hou, René Stulz, and Lu Zhang, for providing intellectual stimulation, invaluable guidance, and extensive comments. All errors are my own.