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Debt Dynamics and Credit Risk

Journal

Journal of Financial Economics

Subject

Finance

Publishing details

Journal of Financial Economics 2023 Vol 149:3 p 497-535

Authors / Editors

Feldhutter P;Schaefer S

Biographies

Stephen Schaefer

Publication Year

2023

Abstract

We investigate how the dynamics of corporate debt policy affect the pricing of corporate bonds. We find empirically that debt issuance has a significant stochastic component that is imperfectly correlated with shocks to asset value. As a consequence, the volatility of leverage is significantly higher than asset volatility over short horizons. At long horizons, the relation between leverage and asset volatility is reversed due to mean reversion in leverage. We incorporate these stochastic debt dynamics into structural models of credit risk, both standard diffusion models as well as newer models with stochastic volatility and jumps. Including stochastic debt gives more accurate predictions of credit spreads in both the cross-section and the time series.

Keywords

Structural models; Debt levels; Default rates; Default boundary; Credit risk

Available on ECCH

No


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