The myth of the credit spread puzzle

Review of Financial Studies

Finance

Review of Financial Studies 2018 Vol 31:8 p 2897-2942

Feldhutter P;Schaefer S

Stephen Schaefer

2018

We ask whether a standard structural model (Black and Cox (1976)) is able to explain credit spreads on corporate bonds and, in contrast to much of the literature, we find that the model matches the level of investment grade spreads well. Model spreads for speculative grade debt are too low and we find that bond illiquidity contributes to this underpricing. Our analysis makes use of a new approach for calibrating the model to historical default rates that leads to much more precise estimates of investment grade default probabilities.

Credit spread puzzle; Structural models; Black-Cox model; Corporate bond spreads; Default probabilities

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