Hostname: page-component-7c8c6479df-995ml Total loading time: 0 Render date: 2024-03-28T04:59:27.741Z Has data issue: false hasContentIssue false

Leverage Expectations and Bond Credit Spreads

Published online by Cambridge University Press:  07 June 2012

Abstract

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.

Type
Research Articles
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2012

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Altman, E. I. “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, 23 (1968), 589609.CrossRefGoogle Scholar
Avramov, D.; Jostova, G.; and Philipov, A.Understanding Changes in Corporate Credit Spreads.” Financial Analysts Journal, 63 (2007), 90105.CrossRefGoogle Scholar
Beaver, W.; McNichols, M.; and Rhie, J.-W.Have Financial Statements Become Less Informative? Evidence from the Ability of Financial Ratios to Predict Bankruptcy.” Review of Accounting Studies, 10 (2005), 93122.CrossRefGoogle Scholar
Bharath, S. T., and Shumway, T.Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies, 21 (2008), 13391369.CrossRefGoogle Scholar
Black, F., and Scholes, M.The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 81 (1973), 637654.CrossRefGoogle Scholar
Blundell, R., and Bond, S.Initial Conditions and Moment Restrictions in Dynamic Panel Data Models.” Journal of Econometrics, 87 (1998), 115143.CrossRefGoogle Scholar
Campbell, J. Y., and Taksler, G. B.Equity Volatility and Corporate Bond Yields.” Journal of Finance, 58 (2003), 23212349.CrossRefGoogle Scholar
Chen, L.; Lesmond, D. A.; and Wei, J.Corporate Yield Spreads and Bond Liquidity.” Journal of Finance, 62 (2007), 119149.CrossRefGoogle Scholar
Collin-Dufresne, P., and Goldstein, R. S.Do Credit Spreads Reflect Stationary Leverage Ratios?Journal of Finance, 56 (2001), 19291957.CrossRefGoogle Scholar
Collin-Dufresne, P.; Goldstein, R. S.; and Martin, J. S.The Determinants of Credit-Spread Changes.” Journal of Finance, 56 (2001), 21772207.CrossRefGoogle Scholar
Das, S. R.; Hanouna, P.; and Sarin, A.Accounting-Based versus Market-Based Cross-Sectional Models of CDS Spreads.” Journal of Banking and Finance, 33 (2009), 719730.CrossRefGoogle Scholar
Dastidar, S.“Does Asset Supply Affect Asset Prices? Evidence from the Agency Bond Market.” Working Paper, Columbia University (2008).CrossRefGoogle Scholar
Duffie, D.; Saita, L.; and Wang, K.Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics, 83 (2007), 635665.CrossRefGoogle Scholar
Elton, E. J.; Gruber, M. J.; Agrawal, D.; and Mann, C.Explaining the Rate Spread on Corporate Bonds.” Journal of Finance, 56 (2001), 247277.CrossRefGoogle Scholar
Eom, Y. H.; Helwege, J.; and Huang, J.-Z.Structural Models of Corporate Bond Pricing: An Empirical Analysis.” Review of Financial Studies, 17 (2004), 499544.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.Industry Costs of Equity.” Journal of Financial Economics, 43 (1997), 153193.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.Testing Tradeoff and Pecking Order Predictions about Dividends and Debt.” Review of Financial Studies, 15 (2002), 133.CrossRefGoogle Scholar
Faulkender, M.; Flannery, M. J.; Hankins, K. W.; and Smith, J. M.Cash Flows and Leverage Adjustments.” Journal of Financial Economics, 103 (2012), 632646.CrossRefGoogle Scholar
Fischer, E. O.; Heinkel, R.; and Zechner, J.Dynamic Capital Structure Choice: Theory and Tests.” Journal of Finance, 44 (1989), 1940.CrossRefGoogle Scholar
Flannery, M. J., and Rangan, K. P.Partial Adjustment Toward Target Capital Structures.” Journal of Financial Economics, 79 (2006), 469506.CrossRefGoogle Scholar
Frank, M. Z., and Goyal, V. K.Testing the Pecking Order Theory of Capital Structure.” Journal of Financial Economics, 67 (2003), 217248.CrossRefGoogle Scholar
Hillegeist, S. A.; Keating, E. K.; Cram, D. P.; and Lundsted, K. G.Assessing the Probability of Bankruptcy.” Review of Accounting Studies, 9 (2004), 534.CrossRefGoogle Scholar
Hui, C. H.; Lo, C. F.; and Huang, M. X.Are Corporates’ Target Leverage Ratios Time-Dependent?International Review of Financial Analysis, 15 (2006), 220236.CrossRefGoogle Scholar
Kisgen, D. J. “Credit Ratings and Capital Structure.” Journal of Finance, 61 (2006), 10351072.CrossRefGoogle Scholar
Krishnan, C. N. V.; Ritchken, P. H.; and Thomson, J. B.Monitoring and Controlling Bank Risk: Does Risky Debt Help?Journal of Finance, 60 (2005), 343378.CrossRefGoogle Scholar
Leary, M. T., and Roberts, M. R.Do Firms Rebalance Their Capital Structure?Journal of Finance, 60 (2005), 25752619.CrossRefGoogle Scholar
Lemmon, M. L.; Roberts, M. R.; and Zender, J. F.Back to the Beginning: Persistence and the Cross- Section of Corporate Capital Structure.” Journal of Finance, 63 (2008), 15751608.CrossRefGoogle Scholar
Lemmon, M. L., and Zender, J. F.Debt Capacity and Tests of Capital Structure Theories.” Journal of Financial and Quantitative Analysis, 45 (2010), 11611187.CrossRefGoogle Scholar
Longstaff, F. A.; Mithal, S.; and Neis, E.Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market.” Journal of Finance, 60 (2005), 22132253.CrossRefGoogle Scholar
Merton, R. C. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449470.Google Scholar
Newman, Y., and Rierson, A.“Illiquidity Spillovers: Theory and Evidence from European Telecom Bond Issuance.” Working Paper, Stanford University (2004).CrossRefGoogle Scholar
Ohlson, J. A. “Financial Ratios and the Probabilistic Prediction of Bankruptcy.” Journal of Accounting Research, 18 (1980), 109131.CrossRefGoogle Scholar
Sarig, O., and Warga, A.Bond Price Data and Bond Market Liquidity.” Journal of Financial and Quantitative Analysis, 24 (1989), 367378.CrossRefGoogle Scholar
Shumway, T.Forecasting Bankruptcy More Accurately: A Simple Hazard Model.” Journal of Business, 74 (2001), 101124.CrossRefGoogle Scholar
Shyam-Sunder, L., and Myers, S. C.Testing Static Tradeoff against Pecking Order Models of Capital Structure.” Journal of Financial Economics, 51 (1999), 219244.CrossRefGoogle Scholar
Sweeney, R. J.; Warga, A. D.; and Winters, D.The Market Value of Debt, Market versus Book Value of Debt, and Returns on Assets.” Financial Management, 26 (1997), 521.CrossRefGoogle Scholar
Warga, A. D. “Corporate Bond Price Discrepancies in the Dealer and Exchange Markets.” Journal of Fixed Income, 1 (1991), 716.CrossRefGoogle Scholar
Zmijewski, M. E. “Methodological Issues Related to the Estimation of Financial Distress Prediction Models.” Journal of Accounting Research, 22 (1984), 5982.CrossRefGoogle Scholar