A Model of Corporate Bond Prices with Dynamic Capital Structure

Abstract

This paper presents an analytical model of corporate discount bond prices. The critical assumption of the model is that the dynamics of the firm's debt ratio revert toward a long-term target debt ratio. Default is triggered at high values of the debt ratio. The model predicts that the levels of the credit spreads of long-term bonds are more sensitive to the firm's target debt ratio than its current debt ratio. The case is the opposite for bonds with shorter maturities. The credit spreads predicted by the model are mean-reverting, which is consistent with the empirical evidence from Duffee (1998). The model outperforms that of Longstaff and Schwartz (1995) on bonds from Boise Cascade Corporation.

JEL Classification: G12, G13