Leverage Expectations and Bond Credit Spreads

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