Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure

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Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure

by Hui Chen of the Massachusetts Institute of Technology

January 20, 2008

Abstract: Investors demand high risk premia for defaultable claims, because (i) defaults tend to concentrate in bad times when marginal utility is high; (ii) default losses are high during such times. I build a structural model of financing and default decisions in an economy with business-cycle variations in expected growth rates and volatility, which endogenously generate countercyclical comovements in risk prices, default probabilities, and default losses. Credit risk premia in the calibrated model not only can quantitatively account for the high corporate bond yield spreads and low leverage ratios in the data, but have rich implications for firms' financing decisions.

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