Between the summer of 2007 and the spring of 2009, the U.S. economy was gripped by an acute liquidity and credit crunch, by all accounts, the most severe financial crisis since the Great Depression. Throughout this period of extreme financial turmoil, credit spreads the difference in yields between various private debt instruments and government securities of comparable maturity served as a crucial gauge of the degree of strains in the financial system. In addition, movements in credit spreads were thought to contain important signals regarding the evolution of the real economy and risks to the economic outlook, a view supported by the insights from the large literature on the predictive content of credit spreads or asset prices more generally for economic activity.
The focus on credit spreads is motivated, in part, by financial theories that depart from the Modigliani and Miller [1958] paradigm of frictionless financial markets, theories that emphasize linkages between the quality of borrowers’ balance sheets and their access to external finance. Fluctuations in credit spreads may also reflect shifts in the effective supply of funds offered by financial intermediaries, which, in the presence of financial market frictions, have important implications for the usefulness of credit spreads as predictors of economic activity. In the latter case, a deterioration in the capital position of financial intermediaries leads to a reduction in the supply of credit, causing an increase in the cost of debt finance the widening of credit spreads and a subsequent reduction in spending and production.
In this paper, we examine the relationship between corporate bond credit spreads and economic activity. To do so, we first construct a new credit spread index the “GZ credit spread” that has considerable predictive power for economic activity over the 1973–2010 period. Our approach builds on the recent work of Gilchrist et al. [2009], in that we use prices of individual corporate bonds traded in the secondary market to construct this highly informative financial indicator. According to our results, the predictive ability of the GZ credit spread for future economic activity significantly exceeds that of the widely used default risk indicators such as the standard Baa–Aaa corporate bond credit spread and the “paper-bill” spread.
As shown by Philippon [2009], the predictive content of corporate bond credit spreads for economic activity could reflect absent any financial market frictions the ability of the bond market to signal more accurately than the stock market a decline in economic fundamentals prior to a cyclical downturn. To address this issue, we use an empirical credit spread pricing framework to decompose the GZ spread into two components: a component capturing the usual countercyclical movements in expected defaults and a component representing the cyclical changes in the relationship between default risk and credit spreads the so called excess bond premium.
