Debt dynamics and credit risk

Feldhutter, P and Schaefer, S M (2023) Debt dynamics and credit risk. Journal of Financial Economics, 149 (3). pp. 497-535. ISSN 0304-405X OPEN ACCESS


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.

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Item Type: Article
Subject Areas: Finance
Date Deposited: 19 Jul 2023 16:13
Date of first compliant deposit: 19 Jul 2023
Subjects: Debt financing
Financial risk
Corporate bonds
Mathematical models
Last Modified: 02 Sep 2023 19:21

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