Risk Shocks and Credit Spreads

Abstract

What moves corporate bond credit spreads? This paper employs a novel statistical method to extract the shock that accounts for the maximal amount of the forecast error variance of credit spreads over a given forecast horizon. I find that the extracted shock can explain a substantial portion of unpredictable fluctuations in credit spreads. In particular, impulse response functions indicate that it has a significant adverse effect on economic activity and financial markets, and closely resemble those of the risk shock as reported in Christiano et al. (2014). To investigate this interpretation more formally, I identify the risk shock using the VIX index as a measure of uncertainty proposed by Bloom (2009) and show that surprisingly, the two shocks are intimately related despite using different identification procedures. This finding implies that the risk shock is the main driver of movements in credit spreads, providing empirical evidence on their strong linkages with macroeconomic dynamics, as well as on their roles in presenting valuable information about future economic activity.