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The Myth of the Credit Spread Puzzle

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  • Peter Feldhütter
  • Stephen M Schaefer

Abstract

Are standard structural models able to explain credit spreads on corporate bonds? In contrast to much of the literature, we find that the Black-Cox model matches the level of investment-grade spreads well. Model spreads for speculative-grade debt are too low, and we find that bond illiquidity contributes to this underpricing. Our analysis makes use of a new approach for calibrating the model to historical default rates that leads to more precise estimates of investment-grade default probabilities. Received October 25, 2016; editorial decision January 12, 2018 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Suggested Citation

  • Peter Feldhütter & Stephen M Schaefer, 2018. "The Myth of the Credit Spread Puzzle," The Review of Financial Studies, Society for Financial Studies, vol. 31(8), pages 2897-2942.
    • Handle: RePEc:oup:rfinst:v:31:y:2018:i:8:p:2897-2942.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhy032
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