Abstract
This study extracts the common factors from firm-based credit spreads of major Japanese corporate bonds and examines the predictive content of the credit spread on the real economy. Instead of employing single-maturity corporate bond spreads, we focus on the entire term structure of the credit spread to predict the business cycle. We extend the dynamic Nelson-Siegel model to allow for both common and firm-specific factors. The results show that the estimated common factors are important drivers of individual credit spreads and have substantial predictive power for future Japanese economic activity. This study contributes to the literature by examining the relationship between firm-based credit spread curves and economic fluctuation and forecasting the business cycle.
Highlights
Predicting the future economy is of great interest to practitioners and policymakers.This study considers whether and how the information contained in the term structure of credit spreads can better forecast the future Japanese economy
We find that the estimated common factors are important drivers of individual credit spreads and that these factors, especially the slope factor, have substantial predictive power for future Japanese economic activity
The dashed line represents how the forecasts of economic activity using the credit common level and slope factors track the year-on-year growth reasonably well in the actual series during recessionary and expansionary times. This finding indicates that the model incorporating credit slope factors better captures the slowdown in economic activity associated with the 2008–2009 recession relative to the model based on mere credit level and macro indicators. These findings are in line with those of previous studies on the relationship between credit spread and the predictive ability for macroeconomic activity
Summary
Predicting the future economy is of great interest to practitioners and policymakers. This study considers whether and how the information contained in the term structure of credit spreads can better forecast the future Japanese economy. Exploring the relationship between credit spreads and future real activity can be motivated by the “financial accelerator” theory developed by Bernanke and Gertler (1989). A key concept in this framework is the external finance premium, the difference between the cost of external funds and the opportunity cost of internal funds due to financial market frictions. The financial accelerator theory argues that a rise in the external finance premium makes outside borrowing costlier, reduces the borrower’s spending and production, and restricts aggregate economic activity. Gilchrist and Zakrajšek (2012) show that a reduction in the supply of credit through a deterioration in financial intermediaries’ creditworthiness leads to the widening of credit spreads and a subsequent reduction in spending and production
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