TY - JOUR AU - Gilchrist, Simon AU - Zakrajšek, Egon TI - Credit Spreads and Business Cycle Fluctuations JF - National Bureau of Economic Research Working Paper Series VL - No. 17021 PY - 2011 Y2 - May 2011 DO - 10.3386/w17021 UR - http://www.nber.org/papers/w17021 L1 - http://www.nber.org/papers/w17021.pdf N1 - Author contact info: Simon Gilchrist Department of Economics New York University 19 West 4th Street. New York, NY, 10003 Tel: 212 992 9770 Fax: NA E-Mail: sg40@nyu.edu Egon Zakrajšek Division of Monetary Affairs Federal Reserve Board 20th Street & Constitution Avenue, NW Washington, D.C. 20551 Tel: 202/728-5864 Fax: 202/452-2846 E-Mail: egon.zakrajsek@frb.gov AB - 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. ER -