Credit Spreads, Daily Business Cycle, and Corporate Bond Returns Predictability

Abstract

The part of credit spread that is not explained by corporate credit risk forecasts future economic activity. I show that the link with aggregate business risk and bond liquidity risk explains this finding. Once I project spreads on these two risk factors, which are readily measurable with the daily frequency, in addition to corporate credit risk, the forecasting power of the residual spread reduces substantially for some macro variables and disappears entirely for the others. Such residual, however, turns out to be an out-of-sample forecast of corporate bond market returns. An investment strategy based on such forecasts delivers risk-adjusted returns 50% higher than the corporate bond market.

Keywords: credit spreads, corporate bond returns, business cycle, predictability of returns

JEL Classification: E44, G12, G17