How Inflation Volatility and Cyclicality Affect Credit Spreads

Summary

The document asks how inflation risk can affect corporate bond spreads, drawing on Kang and Pflueger’s distinction between inflation volatility and inflation’s relationship with real cash flows. It raises questions about why uncertain inflation can raise default risk, how inflation and cash-flow correlation can worsen losses during recessions, and whether local inflation could matter for firms with dollar-denominated debt.

The explanation is framed as a request for clarification rather than a resolved analysis: it offers no data, worked examples, or empirical results. Its core concepts are that volatile inflation can change the real burden of nominal liabilities, while low inflation coinciding with weak real cash flows may intensify firms’ difficulty meeting those liabilities. Applying this to a Turkish company’s dollar debt requires care: the document poses the hypothesis but does not establish its direction or strength. Exchange rates, foreign-currency revenues, and debt terms would also matter, so the discussion alone does not support a general spread prediction.

Key ideas

• Inflation volatility can affect the real burden of nominal corporate liabilities and therefore default risk.
• Inflation’s relationship with real cash flows may matter when weak cash flows coincide with high real debt burdens.
• The document asks whether domestic inflation could affect spreads on dollar-denominated bonds but provides no evidence to settle the question.
• Currency exposure, revenues, and debt terms would be relevant to evaluating the cross-country hypothesis.

Tags

# Understanding the link between inflation and credit spreads


# Understanding the link between inflation and credit spreads












I found a paper which uses inflation as an independant variable for credit spread. Unfortunately, the relationship is not explained in this paper. Further research got my to the paper of Kang/Pflueger (2015, JoF). Here I could need some help understanding what they are writing.

They write:

> Corporate bond spreads price two types of inflation risk: inflation volatility and inflation cyclicality. First, more volatile inflation increases the ex ante probability that firms will default due to high real liabilities.

Question 1: Why does the ex ante probability increases? I would expect that the company faces problems in planning for the future, but is it that what they mean here?

Furthermore they write:

> Second, when inflation and real cash flows are highly correlated, there is a risk of low inflation recessions. In this case, low real cash flows and high real liabilities tend to hit firms at the same time, and this interaction increases default rates and real investor losses.

Question 2: This part is quite difficult to understand. Could someone give an example?

Question 3 (without reference to to KANG and PFLUEGER): Expecting that I only use USD-denominated bonds, but from different countries. Would it be possible to argument that inflation is positively correlated to credit spread since a company from Turkey should face problems paying back their USD-denominated bonds if inflation is high in Turkey?

Any help would be greatly appreciated.

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