Leverage Expectations and Bond Credit Spreads

50 Pages Posted: 29 Nov 2009 Last revised: 24 Feb 2013

See all articles by Mark J. Flannery

Mark J. Flannery

University of Florida - Department of Finance, Insurance and Real Estate

Stanislava (Stas) Nikolova

University of Nebraska - Lincoln

Özde Öztekin

Florida International University (FIU)

Date Written: March 16, 2007

Abstract

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

Keywords: Credit Spreads, Capital Structure, Trade-off Theory, Pecking Order Theory

Suggested Citation

Flannery, Mark Jeffrey and Nikolova, Stanislava (Stas) and Öztekin, Özde, Leverage Expectations and Bond Credit Spreads (March 16, 2007). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1308172 or http://dx.doi.org/10.2139/ssrn.1308172

Mark Jeffrey Flannery

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-3184 (Phone)
352-392-0103 (Fax)

Stanislava (Stas) Nikolova

University of Nebraska - Lincoln ( email )

Lincoln, NE 68588-0490
United States
402-472-6049 (Phone)

Özde Öztekin (Contact Author)

Florida International University (FIU) ( email )

University Park
11200 SW 8th Street
Miami, FL 33199
United States

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