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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