Credit Risk and the Macro Economy in an Affine Term Structure Model

Abstract

The interrelations between corporate lending conditions and the macro economy are becoming increasingly important, particularly in the context of bank regulation and monetary policy. In this paper, I develop a joint affine macro-finance model of the term structures of US Treasury yields and US corporate bond yields. A model with inflation, industrial production growth and three latent factors is able to explain the dynamics of a wide range of rating classes and maturities. An economy-wide latent credit risk factor is identified to study the role of credit conditions in the business cycle. In-sample model dynamics and out-of-sample macroeconomic forecasts provide evidence that credit conditions contain information about the business cycle that are not contained in the Treasury term structure. Therefore, credit conditions form an integral part of the transmission process of monetary policy and highlight the necessity to integrate credit information into policymakers' theoretical business cycle models.