Carolin Pflueger, Business Economics PhD
Thesis Chair: Luis Viceira
Dissertation Title: Inflation and Asset Prices
Job Market Paper: Inflation Risk in Corporate Bonds with H. J. Kang
Do corporate bond spreads reflect fear of debt deflation? Most corporate bonds have fixed nominal face values, so unexpectedly low inflation raises firms' real debt burdens and increases default risk. We develop a real business cycle model with time-varying inflation risk and optimal, but infrequent, capital structure choice. In this model, more volatile or more procyclical inflation lead to quantitatively important credit spread increases. This is true even with inflation volatility as moderate as that in developed economies since 1970. Intuitively, this result obtains because inflation persistence generates large uncertainty about the price level at long maturities and because firms cannot adjust their capital structure immediately.
We find strong empirical support for our model predictions in a panel of six developed economies. Both inflation volatility and the inflation-stock return correlation have varied substantially over time and across countries. They jointly explain as much variation in credit spreads as do equity volatility and the dividend-price ratio. Credit spreads rise by 15 basis points if either inflation volatility or the inflation-stock return correlation increases by one standard deviation. Firms counteract higher debt financing costs by adjusting their capital structure in times of higher inflation uncertainty.
