Leverage Expectations and Bond Credit Spreads

Abstract

In an efficient market, spreads will reflect both the issuer’s current risk and investors’ expectations about how that risk might change over time. Collin-Dufresne and Goldstein (2001) show analytically that a firm’s expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors’ expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.