Predicting the US Real GDP Growth Using Yield Spreads of Corporate Bonds

In general, the yield spread between long- and short-term bonds contains useful information for future economic activity and inflation. Particularly, it usually reflects market participants' expectations of future monetary policy and credit demand. However, it is becoming increasingly difficult to extract such information from the yield spread of government bonds in the US because of the impact of the so-called "flight to quality" where investors seek refuge in risk-free government bonds during a financial crisis, and also because of a reduction in the new issue of such bonds. This paper examines the power of the yield spread of corporate bonds as a substitute for government bonds in predicting economic activity. From empirical studies, we find that the yield spread of corporate bonds is a more effective predictor than government bonds for economic activity. Since the mid-1990s, the US fiscal balance has rapidly improved. As a result, the risk premium stemming from accumulating public debt has decreased, leading to the structural narrowing of the yield spread. After excluding the impact of the improved fiscal situation, we find that the yield spreads of both corporate and government bonds provide more useful information for future economic activity. Considering the relatively stable credit risk premium observed in corporate bond yields, more attention should be paid to the information contained in the yield spread of corporate bonds for future economic activity. Our estimation indicate that the current level of yield spread of corporate bonds predicts the strong continuous expansion of the U.S. economy extending into the near future.