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This paper empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Leland and Toft (1996), Longsta# and Schwartz (1995), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986-1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet su#er from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely a#ecting the spreads of the safest bonds.

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This paper explores the e¡ect of equity volatility on corporate bond yields. Panel data for the late 1990s show that idiosyncratic ¢rm-level volatility can explain as much cross-sectional variation in yields as can credit ratings. This ¢nding, together with the upward trend in idiosyncratic equity volatility documented by Campbell, Lettau, Malkiel, and Xu (2001), helps to explain recent increases in corporate bond yields. DURING THE LATE 1990s, THE U.S. EQUITY and corporate bond markets behaved very di¡erently. As displayed in Figure 1, stock prices rose strongly, while at the same time, corporate bonds performed poorly. The proximate cause of the low returns on corporate bonds was a tendency for the yields on both seasoned and newly issued corporate bonds to increase relative to the yields of U.S.Treasury securities. These increases in corporate^Treasury yield spreads are striking because they occurred at a time when stock prices were rising; the optimism of stock market investors did not seem to be shared by investors in the corporate bond market.

wish to thank Andre Haris, Lozan Bakayatov, and Davron Yakubov for their excellent data collection efforts. In addition, we thank the financial assistance of the Social Sciences and Humanities Research Council of Canada. All errors remain the responsibility of the authors. Corporate Yield Spreads and Bond Liquidity We examine whether liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4000 corporate bonds and spanning investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads; and that an improvement of liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers ’ fixed effect and potential endogeneity bias. Our finding mitigates the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants, and suggests that liquidity plays an important role in corporate bond valuation.

This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events (λ Q), but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with λ Q following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in λ Q are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy. THE BURGEONING MARKET FOR SOVEREIGN CREDIT DEFAULT SWAPS (CDS) contracts offers a nearly unique window for viewing investors ’ risk-neutral probabilities of major credit events impinging on sovereign issuers, and their risk-neutral losses of principal in the event of a restructuring or repudiation of external debts. In contrast to many “emerging market ” sovereign bonds, sovereign CDS

Investors value the liquidity and safety of U.S. Treasury bonds. We document this by showing that changes in Treasury supply have large effects on a variety of yield spreads. As a result, Treasury yields are reduced by 72 basis points, on average over the period from 1926-2008. The low yield on Treasuries due to their extreme safety and liquidity suggests that Treasuries in important respects are similar to money. Evidence from quantities supports this idea. When the supply of Treasuries falls, reducing the overall supply of liquid and safe assets, the supply of bank-issued money rises.

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.

This paper is a critical survey of models designed for pricing fixed income securities and their associated term structures of market yields. Our primary focus is on the interplay between the theoretical specification of dynamic term structure models and their empirical fit to historical changes in the shapes of yield curves. We begin by overviewing the dynamic term structure models that have been fit to treasury or swap yield curves and in which the risk factors follow diffusions, jump-diffusion, or have “switching regimes. ” Then the goodness-of-fits of these models are assessed relative to their abilities to: (i) match linear projections of changes in yields onto the slope of the yield curve; (ii) match the persistence of conditional volatilities, and the shapes of term structures of unconditional volatilities, of yields; and (iii) to reliably price caps, swaptions, and other fixed-income derivatives. For the case of defaultable securities we explore the relative fits to historical yield spreads. 1

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