Inflation risk and yield spread changes

Inflation risk explains a significant share of the systematic residual variation in yield spread changes beyond credit factors and intermediation frictions. Movements in expected inflation directly affect the real value of debt and, consequently, bond prices. I show that shocks to inflation expectations, volatility, and cyclicality – derived from inflation swap prices – are important determinants of yield spread movements. Load-ing patterns become more pronounced with higher ex-ante default risk and cash-flow flexibility but weaken with refinancing intensity. To rationalize the findings, I show that the same patterns emerge in a model of debt rollover risk with stochastic inflation and sticky cash flows.