Systemic default and return predictability in the Stock and Bond Markets

Abstract

Using a structural model of default, we construct a measure of systemic default defined as the probability that many firms default at the same time. Our estimation accounts for correlations in defaults between firms through common exposures to shocks. The systemic default measure spikes during recession periods and is strongly correlated with traditional credit-related macroeconomic measures such as the default spread and VIX. Furthermore, our measure predicts future equity and corporate bond index returns, particularly at the one-year horizon, and even after controlling for many traditional return predictors such as the dividend yield, default spread, inflation, and tail risk. These predictability results are robust to out-of-sample tests.