Abstract
We study a structural model that allows us to examine how credit spreads are affected by the interaction of macroeconomic conditions and firm characteristics. Unlike most other structural models, our model explicitly incorporates equilibrium macroeconomic dynamics and models a firm's cash flow as primitive processes. Corporate securities are priced as contingent claims written on cash flows. Default occurs when the firm's cash flow cannot cover the interest payments and the recovery rate is dependent on the economic condition at default. Our model produces the following predictions: (i) credit spread is mostly negatively correlated with interest rate; (ii) credit spread yield curves are upward sloping for low-grade bonds; (iii) firm characteristics have significant effects on credit spreads and these effects also vary with economic conditions. These predictions are consistent with the available empirical evidence and generate implications for further empirical investigation.
Similar content being viewed by others
References
Acharya VV, Bharath ST, Srinivasan A (2003) Understanding the recovery rates on defaulted securities. Working Paper, LBS, Michigan, and Georgia
Alessandrini F (1999) Credit risk, interest rate risk, and the business cycle. J Fixed Income 92:42–53
Altman E, Brady B, Resti A, Sironi A (2002) The link between default and recovery rates: implications for credit risk models and procyclicity. Working paper, New York University
Altman E I, Kishore V M (1996) Almost everything you wanted to know about recoveries on defaulted bonds. Financ Anal J 526:57–64
Alvarez F, Jermann UJ (2000) Efficiency, equilibrium, and asset pricing with risk of default. Econometrica 68:775–797
Anderson RW, Sundaresan S (1996) Design and valuation of debt contracts. Rev Financ Stud 9:37–68
Anderson RW, Sundaresan S (2000) A comparative study of structural models of corporate bond yields: an exploratory investigation. J Bank Financ 24:255–269
Bakshi GS, Chen Z (1997) An alternative valuation model for contingent claims. J Financ Econ 44:123–165
Bakshi GS, Madan D, Zhang F (2004) Investigating the role of systematic and firm-specific factors in default risk: lesson from empirically evaluating credit risk models. Journal Business, forthcoming
Black F, Cox JC (1976) Valuing corporate securities: some effects of bond indenture provisions. J Finance 31:351–367
Black F, Scholes M (1973) The pricing of options and corporate liabilities. J Polit Econ 81:637–654
Bohn JR (1999) Characterizing credit spreads. Working paper, University of California at Berkeley
Brennan MJ, Schwartz ES (1984) Corporate income taxes, valuation, and the problem of optimal capital structure. J Bus 51:103–114
Campbell JY, Cochrane JH (1999) By force of habit: a consumption-based explanation of aggregate stock market behavior. J Polit Econ 107:205–251
Campbell JY, Taksler GB (2003) Equity volatility and corporate bond yields. J Finance 58:2321–2349
Campbell JY, Vuolteenaho T (2004) Bad beta, good beta. Am Econ Rev 94:1249–1275
Chang G, Sundaresan S (2005) Asset prices and default-free term structure in an equilibrium model of default. J Bus 78:997–1021
Chen L, Collin-Dufresne P, Goldstein RS (2005) On the relation between credit spread puzzles and the equity premium puzzle. Working paper, Michigan State, Minnesota and Berkeley
Claus J, Thomas J (2001) Equity premia as low as three percent? Evidence from analysts’ earnings forecasts for domestic and international stock markets. J Finance 55:1629–1666
Collin-Dufresne P, Goldstein RS (2001) Do credit spreads reflect stationary leverage ratios? J Finance 56:2177–2207
Collin-Dufresne P, Goldstein RS, Martin JS (2001) The determinants of credit spread changes. J Finance 56:2177–2207
Covitz D, Downing C (2002) Insolvency or liquidity squeeze? Explaining very short-term corporate yield spreads. Working paper, Federal Reserve Board
Cox JC, Ingersoll JE, Ross SA (1985) An intertemporal general equilibrium model of asset prices. Econometrica 53:363–384
Cremers M, Driessen J, Maenhout P, Weinbaum D (2004) Individual stock-option prices and credit spreads. Working paper, Yale University
David A (2004) Dynamics of the credit risk premium: the effects of inflation and earnings uncertainty. Working paper, Washington University in St. Louis
Detemple JB (1986) Asset pricing in a production economy with incomplete information. J Finance 41:383–392
Dothan MU, Feldman D (1986) Equilibrium interest rates and multiperiod bonds in a partially observable economy. J Finance 41:369–382
Duffee G (1998) The relation between Treasury yields and corporate bond yield spreads. J Finance 53:2225–2242
Duffie D, Lando D (2001) Term structures of credit spreads with incomplete accounting information. Econometrica 69:633–664
Duffie D, Singleton KJ (1997) An econometric model of the term structure of interest rate swap yields. J Finance 52:1287–1321
Duffie D, Singleton K (1999) Modeling term structures of defaultable bonds. Rev Financ Stud 12:687–720
Duffie D, Singleton KJ (2003) Credit risk: pricing, measurement, and management. Princeton University Press
Duffie D, Saita L, Wang K (2005) Multi-period corporate default prediction with stochastic covariates. J Financ Econ, forthcoming
Elton EJ, Gruber MJ, Agrawal D, Mann C (2001) Explaining the rate spread on corporate bonds. J Finance 56:247–277
Eom YH, Helwege J, Huang J-Z (2004) Structural models of corporate bond pricing: an empirical analysis. Rev Financ Stud 17:499–544
Fama EF, French KR (1989) Business conditions and expected returns on stocks and bonds. J Financ Econ 25:23–49
Fan H, Sundaresan SM (2000) Debt valuation, renegotiation, and optimal dividend policy. Rev Financ Stud 13:1057–1099
Fischer EO, Heinkel R, Zechner J(1989) Dynamic capital structure choice: theory and tests. J Finance 44:19–40
Fridson M, Jonsson J (1995) Spread versus Treasuries and the riskiness of high-yield bonds. J Fixed Income 5:79–88
Gennotte G (1986) Optimal portfolio choice under incomplete information. J Finance 41:733–746
Geske R (1977) The valuation of corporate liabilities as compound options. J Financ Quant Anal 12:541–552
Goldstein R, Zapatero F (1996) General equilibrium with constant relative risk aversion and vasicek interest rates. Math Financ 6:331–340
Goldstein R, Ju N, Leland H (2001) An EBIT-based model of dynamic capital structure. J Bus 74:483–512
Guha R (2003) Recovery of face value at default: empirical evidence and implications for credit risk pricing. Working paper, London Business School
Gupton GM, Stein RM (2002) LossCalc: Moody’s model for predicting loss given default (LGD). Working Paper, Moody’s Investors Services, Global Credit Research, New York
Hackbarth D, Miao J, Morellec E (2004) Capital structure, credit risk, and macroeconomic conditons. J Financ Econ, forthcoming
Helwege J, Turner CM (1999) The slope of the credit yield curve for speculative-grade issuers. J Finance 54:1869–1884
Huang J-Z, Huang M (2003) How much of credit spread is due to credit risk? Working Paper, Penn State and Stanford University
Jacoby G (2002) On estimating the relation between corporate bond yield spreads and Treasury yields. Working paper, University of Manitoba
Jarrow RA, Turnbull S (1995) Pricing derivatives on financial securities subject to default risk. J Finance 50:53–86
Jarrow RA, Turnbull SM (2000) The intersection of market and credit risk. J Bank Financ 24:271–299
Jarrow RA, Lando D, Turnbull SM (1997) A Markov model for the term structure of credit risk spreads. Rev Financ Stud 10:481–523
John K, Lynch AW, Puri M (2003) Credit ratings, collateral, and loan characteristics: implications for yields. J Bus 76:371–409
Jones EP, Mason SP, Rosenfeld E (1984) Contingent claims analysis of corporate capital structures: an empirical analysis. J Finance 39:611–625
Kim IJ, Ramaswamy K, Sundaresan S (1993) Does default risk in coupons affect the valuation of corporate bonds?: a contingent claims model. Financ Manage 22(Special issue on financial distress):117–131
Korajczyk RA, Levy A (2003) Capital structure choice: macroeconomic conditions and financial constraints. J Financ Econ 68:75–109
Lando D (1998) On Cox processes and credit risky securities. Rev Deriv Res 2:99–120
Leland HE, (1994) Risky debt, bond covenants, and optimal capital structure. J Finance 49:1213–1252
Leland HE (1998) Agency costs, risk management, and capital structure. J Finance 53:1213–1243
Leland HE (2004) Predictions of default probabilities in structural models of debt. J Investm Manag 2(2):5–20
Leland HE, Toft K (1996) Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads. J Finance 51:987–1019
Longstaff FA, Schwartz ES (1995) A simple approach to valuing risky fixed and floating rate debt. J Finance 50:789–819
Lucas RE (1978) Asset prices in an exchange economy. Econometrica 46:1429–1445
Madan D, Unal H (1998) Pricing the risks of default. Rev Deriv Res 2:121–160
Marsh TA, Yan H (2002) The equilibrium risk structure of interest rates. Working paper, University of Texas at Austin
Mella-Baral P (1999) The dynamics of default and debt reorganization. Rev Financ Stud 12:535–578
Mella-Baral P, Perraudin W (1997) Strategic debt service. J Finance 52:531–556
Merton RC (1974) On the pricing of corporate debt: the risk structure of interest rates. J Finance 29:449–470
Minton BA, Schrand C (1999) The impact of cash flow volatility on discretionary investment and the costs of debt and equity financing. J Financ Econ 54:423–460
Moody’s Investors Service (2002) Default and recovery rates of corporate bond issuers: a statistical review of Moody's ratings performance 1970–2001. Special Comment
Morellec E (2001) Asset liquidity, capital structure, and secured debt. J Financ Econ 61:73–206
Nielsen SS, Ronn EI (1996) The valuation of default risk in corporate bonds and interest rate swaps. Working paper, University of Texas at Austin
Pesaran MH, Schuermann T, Treutler B-J, Weiner SM (2003) Macroeconomic dynamics and credit risk: a global perspective. J Money, Credit Bank, forthcoming
Santos T, Veronesi P (2006) Labor income and predictable stock returns. Rev Financ Stud 19:1–44
Sarig O, Warga A (1989) Some empirical estimates of the risk structure of interest rates. J Finance 44:1351–1360
Shleifer A, Vishny R (1992) Liquidation values and debt capacity: a market equilibrium approach. J Finance 47:1343–1366
Thorburn KS (2000) Bankruptcy anctions: costs, debt recovery and firm survival. J Financ Econ 58:337–358
Titman S, Torous WN (1989) Valuing commercial mortgages: an empirical investigation of the contingent-claim approach to pricing risky debt. J Finance 44:345–373
Titman S, Tompaidis S, Tsyplakov S (2004) Market imperfections, investment flexibility, and default spreads. J Finance 59:165–205
Uhrig-Homburg M (2005) Cash-flow shortage as an endogenous bankruptcy reason. J Bank Financ 29:1509–1534
Vasicek O (1977) An equilibrium characterization of the term structure. J Financ Econ 5:177–188
Wilson TC (1997a) Portfolio credit risk (1). Risk 10(9):111–116
Wilson TC (1997b) Portfolio credit risk (2). Risk 10(10):56–61
Wruck KH (1990) Financial distress, reorganization, and organizational efficiency. J Financ Econ 27:419–444
Zhou C (2001) The term structure of credit spreads with jump risk. J Bank Financ 25:2015–2040
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Tang, D.Y., Yan, H. Macroeconomic Conditions, Firm Characteristics, and Credit Spreads. J Finan Serv Res 29, 177–210 (2006). https://doi.org/10.1007/s10693-006-7625-y
Received:
Revised:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10693-006-7625-y