Do Credit Spreads Reflect Stationary Leverage Ratios?
ABSTRACT Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean‐reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low‐leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative‐grade debt, consistent with recent empirical findings.
Authors: Pierre Collin‐Dufresne, Robert S. Goldstein
Citations: 824
Published: 2001-10-01T00:00:00.000Z
Why It Matters
Venue: The Journal of Finance. Year: 2001. Citations: 824. Abstract signal: ABSTRACT Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean‐reverting lev...
Abstract
ABSTRACT Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean‐reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low‐leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative‐grade debt, consistent with recent empirical findings.
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