Inflation Risk in Corporate Bonds

type="main"> <title type="main">ABSTRACT</title> <p>We argue that corporate bond yields reflect fears of debt deflation. When debt is nominal, unexpectedly low inflation increases real liabilities and default risk. In a real business cycle model with optimal but infrequent capital structure choice, more uncertain or procyclical inflation leads to quantitatively important increases in corporate log yields in excess of default-free log yields. A panel of credit spread indexes from six developed countries shows that credit spreads rise by 14 basis points if inflation volatility or the inflation-stock correlation increases by one standard deviation.