Do Credit Spreads Reflect Stationary Leverage Ratios?


  • Pierre Collin-Dufresne,

  • Robert S. Goldstein

    Search for more papers by this author
    • Pierre Collin-Dufresne is from the Graduate School of Industrial Administration, Carnegie Mellon University and Robert S. Goldstein is from Washington University, St. Louis. The work was completed while Goldstein was at Ohio State University. We thank Brian Betker, Mark Carey, Greg Duffee, Erwan Morellec, Rick Green, Jean Helwege, Edith Hotchkiss, Jan Jindra, Francis Longstaff, Dilip Madan, Tim Opler, René Stulz (the editor), and two anonymous referees for helpful comments.


Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean-reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low-leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative-grade debt, consistent with recent empirical findings.