Corporate Bond Risk and Real Activity: An Empirical Analysis of Yield Spreads and their Systematic Components

Abstract

The views expressed in this Working Paper are those ofthe author(s) and do not necessarily represent those of the IMF or IMF policy.Working Papers describe research in progress by the author(s) and are published to elicit conunents and to further debate.This paper finds that the yield spread of investment-grade bonds relative to Treasuries, a proxy of default risk, predicts marginal changes in industrial production in the United States up to 12 months in the future, even upon controlling for a commonly used predictor such as the commercial paper spread.The paper also finds that systematic risk factors associated with the yield spread of investment-grade bonds to a variety of risk-free benchmarks-Treasuries, agency bonds, and AAA-rated bonds -have significant predictive content for future growth rate of industrial production at 3 to 18 months forecasting horizon, both in-and out-of-sample.Finally, a regime-switching estimation shows that the systematic risk component is also able to capture "industrial production business cycle" well.