The Myth of the Credit Spread Puzzle
61 Pages Posted: 5 Dec 2013 Last revised: 16 Jan 2018
Date Written: January 14, 2018
We ask whether a standard structural model (Black and Cox (1976)) is able to explain credit spreads on corporate bonds and, in contrast to much of the literature, we find that the model matches the level of investment grade spreads well. Model spreads for speculative grade debt are too low and we find that bond illiquidity contributes to this underpricing. Our analysis makes use of a new approach for calibrating the model to historical default rates that leads to much more precise estimates of investment grade default probabilities.
Keywords: Credit spread puzzle, Merton model, Structural models, Corporate bond spreads, Realized default frequencies
JEL Classification: C23, G01, G12
Suggested Citation: Suggested Citation