Using Yield Spreads to Estimate Expected Returns on Debt and Equity

Abstract

This paper develops and tests a method of extracting expectations about default losses on corporate debt from yield spreads. It is based on calibrating theMerton (1974) model to yield spread, leverage and equity volatility. For rating classes, the approach generates forwardlooking expected default loss estimates similar to historical losses, and is also applicable for individual bonds. The information content of the estimate is superior to linear ex ante functions of the variables it uses as inputs. We also find that estimates of equity risk premia consistent with historical default experiences range from 3.1% for AA companies to 8.5% for B companies.

Keywords: Credit spreads, Expected default, Credit risk, Cost of capital, Equity premium

JEL Classification: G12; G32; G33