Abstract

Standard macroeconomic models imply that credit spreads directly reáect expected losses (the probability of default and the loss in the event of default). In contrast, in the data credit spreads are signiÖcantly larger than expected losses, suggestive of an aggregate risk premium. Building on the idea that corporate debt, while safe in normal times, is exposed to economic depressions, this paper embeds a trade-o§ theory of capital structure into a real business cycle model with a small, time-varying risk of economic disaster. The model replicates the level, volatility and cyclicality of credit spreads, and variation in the corporate bond premium ampliÖes macroeconomic áuctuations in investment, employment and GDP.