Daniel Streitz, Halle Institute for Economic Research
Abstract: High yield firms nowadays almost exclusively issue bonds that are callable.We construct a new measure of option moneyness and show that these firms aggressively exercise the interest rate and spread option implicit in these contracts. Controlling for moneyness, firms frequently prepay bonds and issue new debt if rollover risk is high. We develop and estimate a structural model to quantify the costs and benefits of dynamically managing this risk. The ability to use callable debt almost entirely dissipates dead-weight losses from rollover risk. Creditor-shareholder conflicts reduce the effectiveness of this dynamic hedging strategy for highly levered firms.
Abstract: I study a preferred-habitat model of the term structure in which the same marginal investor prices government and corporate bonds. The model endogenously generates variation in credit spreads over and above changes in credit quality. In equilibrium, credit spreads are affine functions of the aggregate risk factors, providing an equilibrium justification to credit risk valuation models. Risk premia on interest rate and credit risk are time-varying and jointly determined. Arbitrage activity strengthens the risk-neutral dependence between the aggregate risk factors beyond the observed correlation between default rates and the policy rate. Movements in credit spreads are driven by (i) variation in credit quality (ii) risk-neutral correlation of the risk factors, and (iii) portfolio rebalancing due to diversification motives. A calibrated model matches the level and the slope of the term structure of credit spreads for both investment-grade and high-yield issuers. As government bonds hedge against default risk, the strength of monetary policy transmission to corporate (Treasury) yields is weaker (stronger) when default uncertainty increases. Shocks to the short term rate move credit spreads by altering risk premia on both credit and interest rate risk. The impact of quantitative easing interventions is asymmetric and depends on the specific assets being purchased.
Discussant: Lorenzo Garlappi, University of British Columbia
Abstract: Models of learning about economic crises generate risk premia that rise at the onset of a crisis, but then fall as belief uncertainty fades. In contrast, empirical risk premia remain elevated during crises. We resolve this tension via leverage dynamics generated by the impact of learning on optimal default and capital structure decisions within a representative agent consumption-based model. Leverage surges and remains elevated during a crisis, because optimal default boundaries rise as the agent learns the economy is in crisis as opposed to a mere recession. Elevated leverage keeps the equity premium and credit spreads persistently high as the crisis unfolds. We structurally estimate the model and show it closely matches the joint dynamics of consumption, equity risk premia, credit risk, and leverage, especially during crises, together with the term structure of credit risk and default probabilities.
Discussant: Sang Byung Seo, University of Wisconsin-Madison
