Inflation Risk in Corporate Bonds

Abstract

We argue that corporate bond yields reflect fear of debt deflation. Most bonds are nominal, so unexpectedly low inflation raises firms' real leverage and increases defaults. In a real business cycle model with time-varying inflation risk and optimal but infrequent capital structure, more volatile or pro-cyclical inflation leads to quantitatively important increases in corporate -default free yield spreads. Consistent with model predictions, we find in a panel of six developed countries that credit spreads increase by 14 basis points if either inflation volatility or the inflation-stock correlation increases by one standard deviation.Kang: Harvard Business School, Boston MA 02163. hjkang@hbs.edu. Pflueger: University of British Columbia, Vancouver BC V6T 1Z2, Canada. carolin.pflueger@sauder.ubc.ca. We are grateful to an anonymous referee, Shai Bernstein, Josh Coval, Ben Friedman, Josh Gottlieb, Francois Gourio, Robin Greenwood, Robert Hall, Sam Hanson, Stephanie Hurder, Jakub Jurek, Jacob Leshno, Robert Merton, Nick Roussanov, Alp Simsek, Jeremy Stein, Jim Stock, Adi Sunderam, seminar participants at the University of British Columbia, Brown University, the Federal Reserve Board, the Federal Reserve Bank of Chicago, Harvard University, the University of Illinois at Urbana-Champaign, London Business School, the University of Michigan, the University of Rochester, Washington University in St. Louis, the University of Wisconsin-Madison, and the Yale School of Management for helpful comments and suggestions. We are especially grateful to John Campbell, Erik Stafford, and Luis Viceira for invaluable advice and guidance.Bonds in the developed world overwhelmingly carry fixed nominal face values, so real values fluctuate with inflation. When corporate debt is nominal, firms can be driven into default by either a decrease in real cash flows or an increase in real liabilities. The literature has argued that the volatility of real firm values is priced into corporate bond spreads. We find that inflation risk plays at least as large a role in explaining variation in the spread between corporate bond yields and default-free bond yields.Inflation cyclicality -as proxied by the inflation-stock correlation -peaked during the financial crisis, when inflation dropped to extremely low levels. Our results therefore indicate that concerns about debt deflation (Fisher (1933)) and potentially important macroeconomic feedback effects (Bernanke and Gertler (1989), Kiyotaki and Moore (1997)) are of renewed relevance today.Inflation risk can increase credit spreads in two ways. First, more volatile inflation increases the ex ante probability that firms will default due to high real liabilities. Second, when inflation and real cash flows are highly correlated, low real cash flows and high real liabilities tend to hit firms at the same time, increasing default rates and real investor losses. In this second case, higher credit spreads reflect higher expected credit losses and a higher risk premium due to the greater concentration of ...

Stocks, bonds, T-bills and inflation hedging: From great moderation to great recession

“…4 The literature has provided various explanations for the negative effect of inflation rates on stock returns that several studies report for short-term investment horizons. Among these explanations are the proxy effect (Fama, 1981;Kaul, 1987), money illusion (Modigliani & Cohn, 1979), and informational frictions (Barnes et al, 1999). The proxy hypothesis is based on the assumption that stock prices are driven by a company's future earnings potential.…”

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