Date Added: May 2011
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, the authors 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, they decompose the index into a predictable component that captures the available firm-specific information on expected defaults and a residual component - the excess bond premium. The results indicate that the predictive content of credit spreads is due primarily to movements in the excess bond premium.