Debt Dynamics and Credit Risk

The dynamics of debt are crucial in structural models of credit risk and this paper provides new empirical evidence on these dynamics. For US industrial firms, we find that the future level of debt is negatively related to current leverage. Furthermore, when a firm experiences a negative shock to its equity, debt increases in the short run but declines in the long run, relative to a positive-shock firm. We incorporate these features into a new structural model of credit risk and compare the model's ability to match the cross-section of US credit spreads with that of existing models. The model provides more accurate predictions of credit spreads, particularly for short-maturity investment grade debt