Issuer Quality and the Credit Cycle

Abstract:     
We show that the credit quality of corporate debt issuers deteriorates during credit booms, and that this deterioration forecasts low excess returns to corporate bondholders. The key insight is that changes in the pricing of credit risk disproportionately affect the financing costs faced by low quality firms, so the debt issuance of low quality firms is particularly useful for forecasting bond returns. We show that a significant decline in issuer quality is a more reliable signal of credit market overheating than rapid aggregate credit growth. We use these findings to investigate the forces driving time-variation in expected corporate bond returns.

Number of Pages in PDF File: 46

Keywords: credit risk, credit bubbles, forecasting regressions, debt issuance, quality

JEL Classification: G14, G32

working papers series