Structural Models of Corporate Bond Pricing: An Empirical Analysis

Abstract

This article empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Longstaff and Schwartz (1995), Leland and Toft (1996), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986-1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations, we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet suffer from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds. The seminal work of Black and Scholes (1973) and Merton (1974) in the area of corporate bond pricing has spawned an enormous theoretical literature on risky debt pricing. One motivating factor for this burgeoning literature is the perception that the Merton model cannot generate sufficiently high-yield spreads to match those observed in the market. Thus the recent theoretical literature includes a variety of extensions and We are grateful to an anonymous referee and especially Ken Singleton and Maureen O'Hara (the editors) for detailed and helpful comments and suggestions. We also thank

Unresolved Issues in Modeling Credit-Risky Assets

“…In the second approach, Eom, Helwege, and Huang [2004] test five different structural models. They use firmspecific parameters such as firm value, leverage, and payout ratio based on historical corporate data.…”

Credit Default Swaps

“…They conclude that the CDS premiums implied are significantly higher than the CDS market prices. Eom, Helwege, and Huang [2004] test the performance of models by Merton [1974], Geske [1977], Longstaff and Schwartz [1995], Leland andToft [1996], andCollin-Dufresne andGoldstein [2001]. They find that the credit spreads predicted by Merton [1974] and Geske [1977] are too low; and the spreads predicted by Longstaff and Schwartz [1995], Leland andToft [1996], andCollin-Dufresne andGoldstein [2001] are too high.…”

The Company Fundamental Analysis and the Default Risk Ratio

“…The main problem is that the asset volatility employed in structural models is not directly observable and it has to be estimated indirectly by using different indicators such as equity volatility. Several recent studies show that the difficulty of structural models explain yield spreads (Huang and Huang, 2012;Bao, 2009;Cremers et al, 2008;Eom et al, 2004;Schaefer and Strebulaev, 2008;Chen et al, 2007). Duffie and Singleton (1999) among others, are based on a statistical approach and they are abstracted away completely from the economic definition of bankruptcy and default treats that are considered as exogenously specified process.…”