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Issuer Quality and Corporate Bond Returns

date Date: February 1, 2014
date Author(s): Robin Greenwood and Samuel G. Hanson
date Affiliation: Harvard University
Abstract

We show that the credit quality of corporate debt issuers deteriorates during credit booms, and
that this deterioration forecasts low excess returns to corporate bondholders. The key insight is
that changes in the pricing of credit risk disproportionately affect the financing costs faced by
low quality firms, so the debt issuance of low quality firms is particularly useful for forecasting
bond returns. We show that a significant decline in issuer quality is a more reliable signal of
credit market overheating than rapid aggregate credit growth. We use these findings to
investigate the forces driving time-variation in expected corporate bond returns.

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