Working Paper: NBER ID: w17021
Authors: Simon Gilchrist; Egon Zakrajsek
Abstract: This paper examines the evidence on the relationship between credit spreads and economic activity. Using an extensive data set of prices of outstanding corporate bonds trading in the secondary market, we construct a credit spread index that is--compared with the standard default-risk indicators--a considerably more powerful predictor of economic activity. Using an empirical framework, we decompose our index into a predictable component that captures the available firm-specific information on expected defaults and a residual component--the excess bond premium. Our results indicate that the predictive content of credit spreads is due primarily to movements in the excess bond premium. Innovations in the excess bond premium that are orthogonal to the current state of the economy are shown to lead to significant declines in economic activity and equity prices. We also show that during the 2007-09 financial crisis, a deterioration in the creditworthiness of broker-dealers--key financial intermediaries in the corporate cash market--led to an increase in the excess bond premium. These find- ings support the notion that a rise in the excess bond premium represents a reduction in the effective risk-bearing capacity of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.
Keywords: credit spreads; economic activity; excess bond premium
JEL Codes: E22; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit spreads (G12) | economic activity (E20) |
| credit spreads (G12) | equity prices (G12) |
| excess bond premium (G12) | economic activity (E20) |
| excess bond premium (G12) | equity prices (G12) |
| excess bond premium (G12) | consumption (E21) |
| excess bond premium (G12) | investment (G31) |
| excess bond premium (G12) | output (C67) |