Journal of Financial and Quantitative Analysis

Research Articles

Leverage Expectations and Bond Credit Spreads

Mark J. Flannery, Stanislava (Stas) Nikolova and Özde Öztekin, Warrington College of Business Administration, University of Florida, PO Box 117168, Gainesville, FL 32611, U.S. Securities and Exchange Commission, 100 F St NE, Washington, DC 20549, College of Business Administration, Florida International University, 11200 SW 8th St, Miami, FL 33199


In an efficient market, spreads will reflect both the issuer’s current risk and investors’ expectations about how that risk might change over time. Collin-Dufresne and Goldstein (2001) show analytically that a firm’s expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors’ expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.


  We thank Hendrik Bessembinder (the editor), David Brown, Robert Goldstein (the referee), Jean Helwege, Jay Ritter, and seminar participants at American University, Florida State University, 2007 Financial Management Association European Meetings, 2007 European Financial Management Association Annual Meetings, Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) for helpful comments and suggestions on prior drafts of this paper. The SEC disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This paper expresses the authors’ views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. All remaining errors are our own.