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Testing Merton's Model for Credit Spreads on Zero-Coupon Bonds

by Gordon Gemmill of the City University, London

March 2003

Abstract: Structural models for valuing corporate bonds (beginning with Merton (1974)) have been criticised for giving spreads which are (a) too small and (b) have a term structure in which spreads diminish with extra time to maturity. Empirical tests of models are hampered by the complexity of real-world bonds, which have coupons, calls and sinking funds, and also by the complicated and changing capital structures adopted by companies. This paper exploits a new database of zero-coupon bonds issued by closed-end funds in the UK. These companies have very simple capital structures and transparent values for both assets and liabilities. Between 20 and 78 bonds are observable monthly over the period February 1992 to April 2001. Counter to previous research, we find that model and market spreads are on average of similar magnitude. Similar to previous research, market spreads are high (relative to model spreads) for bonds which have low risk and for bonds which are near to maturity. While the observed termucture of credit spreads is upward-sloping, this may be explained by a predictable drift in leverage over time. On the whole, the results are surprisingly supportive of Merton's model and suggest that it is important to allow for expected changes in leverage when computing credit spreads.

Keywords: spread, bond, credit-risk, Merton, closed-end fund.

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