Disentangling Credit Spreads and Equity Volatility

Abstract

In this paper, I provide a structural approach to quantify the forces that govern the joint dynamics of corporate bond credit spreads and equity volatility. I build a dynamic model and estimate a wide array of fundamental shocks using a large firm-level database on credit spreads, equity prices, accounting statements, and bond recovery ratios in the U.S. from 1973 to 2014. A structural decomposition reveals that the joint dynamics of credit spreads and equity volatility is driven by fluctuations in firms’ asset values and aggregate asset volatility. I find that aggregate asset volatility captures the informational content of credit spreads for predicting economic activity. All together, my results suggest that aggregate asset volatility is key for the transmission channel that links the fundamental drivers of financial indicators to the real economy.