Ebook Credit Market Shocks and Economic Fluctuations: Evidence from Corporate Bond and Stock Markets
After markets for securitized credit products collapsed dramatically in the second half of 200 7, growth in a number of industrialized economies slowed markedly, suggesting that disruptions in financial markets can have important macroeconomic consequences. The fact that sharp and sudden deteriorations in financial conditions are typically followed by a prolonged period of economic weakness is a feature of a growing number of economic downturns in the U.S. and abroad.
During periods of credit market turmoil, financial asset prices, owing to their forward looking nature, are especially informative of linkages between the real and financial sides of economy: Movements in asset prices can provide early warning signals for such economic downturns and can be used to gauge the degree of strains in financial markets.
Past research on the role of asset prices in signaling future economic conditions and in propagating economic fluctuations has emphasized the information content of default-risk indicators such as corporate credit spreads the difference in yields between various corporate debt instruments and government securities of comparable maturity for the state of the economy and risks to the economic outlook. In a recent paper, Philippon [2008] provides a theoretical framework in which the predictive content of corporate bond spreads for economic activity absent any financial frictions reflects a general decline in economic fundamentals stemming from a reduction in the expected present value of corporate cash flows prior to a cyclical downturn.
Rising credit spreads can also reflect disruptions in the supply of credit resulting from the worsening in the quality of corporate balance sheets or from the deterioration in the health of financial intermediaries that supply credit the financial accelerator mechanism emphasized by Bernanke, Gertler, and Gilchrist [1999]. In this context, a contraction in credit supply causes asset values to fall, incentives to default to increase, and yield spreads on private debt instruments to widen before economic downturns, as lenders demand compensation for the expected increase in defaults.
In terms of forecasting macroeconomic conditions, the empirical success of this vein of research is considerable. Nevertheless, results vary substantially across different financial instruments underlying credit spreads under consideration as well as across different time periods. For example, the spread of yields between nonfinancial commercial paper and comparable maturity Treasury bills the so called paper-bill spread has lost much of its forecasting power since the early 1990s.
In contrast, yield spreads based on indexes of high yield corporate bonds, which contain information from markets that were not in existence prior to the mid-1980s, have done particularly well at forecasting output growth during the previous decade, according to Gertler and Lown [1999] and Mody and Taylor [2004]. Stock and Watson [2003b], however, find mixed evidence for the high yield spread as a leading indicator during this period, largely because it falsely predicted an economic downturn in the autumn of 1998. This dichotomy of findings is perhaps not surprising, because as financial markets evolve, the information content of specific financial assets prices may change as well.
The fragility of results may also reflect the fact that this research has generally relied on a single credit spread index, rather than on multiple indexes reflecting a broad cross section in terms of both default risk and maturity of private debt instruments.
In addition to focusing on a single credit spread index, researchers often ignore the in formation content of other asset prices when evaluating the forecasting ability of different default risk indicators. Although it is straightforward to control for the general level of equity prices in such analysis, it is usually not possible to obtain equity valuations of the borrowers whose debt securities are used to construct the credit spreads under consideration. Such information could potentially be used to distinguish movements in corporate credit spreads that are due to general trends in financial asset prices associated with a given class of borrowers from the movements in spreads that are specifically related to developments in credit markets.
When assessing the information content of corporate credit spreads for economic activity, it is also important to control accurately for the maturity structure of the underlying credit instruments. The widely used paper-bill spreads, for example, are based on short maturity instruments typically between one and six months whereas the specific maturity structure of corporate bond spread indexes such as the high-yield spread or Baa-Aaa spread though much longer is not generally known.
In general, short term credit instruments reflect near term default risk, whereas longer maturity instruments are likely better at capturing expectations about future economic conditions one to two years ahead, a forecast horizon typically associated with business cycle fluctuations. Thus, a correct assessment of the ability of credit spreads to forecast at business cycle frequencies likely requires careful attention to the maturity structure of securities used to construct credit spreads.
In this paper, we construct credit spreads using monthly data on prices of senior unsecured corporate debt traded in the secondary market over the 1990–2007 period, issued by nearly 1,000 U.S. non financial corporations. In contrast to many other corporate financial instruments, long-term senior unsecured bonds represent a class of securities with a long history containing a number of business cycles, an attribute that is most useful in the valuation process of debt instruments.
In addition, the rapid pace of financial innovation over the past twenty years has done little to alter the basic structure of these securities. Thus, the information content of spreads constructed from yields on senior unsecured corporate bonds is likely to provide more consistent signals regarding economic outcomes relative to spreads based on securities with a shorter history or securities whose structure or the relevant market has underwent a significant structural change. As a result, our measures of corporate bond spreads are less likely to capture “one-off” developments in the financial sector that can reduce the informational content of asset prices for future economic activity.
We exploit the cross-sectional heterogeneity of our data by constructing a broad array of credit spreads that vary across maturity and default risk. Because we observe prices of individual securities, we can assign each bond outstanding at each point in time to a specific category determined by the issuer’s ex-ante expected probability of default and the bond’s remaining term to maturity. In the construction of these “bond portfolios,” we rely on the monthly firm-specific expected default frequencies (EDFs) constructed by the Moody’s/KMV corporation. Because they are primarily based on observable information in equity markets, EDFs provide, arguably, a more objective and certainly more timely assessment of credit risk compared with the issuer’s senior unsecured credit rating. Importantly, by building bond portfolios from the “ground up,” we can also construct portfolios of stock returns corresponding to firms in the same credit-risk categories. These matched portfolios of stock returns, in turn, serve as controls for the news about firms’ future earnings as these corporate borrowers experience shocks to their creditworthiness.
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