Extracting Credit Spreads from Structural Models Via the Payout Ratio

Abstract

I introduce a new way to imply credit spreads from structural models. The proposed measure, CS_POR, is extracted via the payout ratio as the increase in continuous interest payments to creditors necessary to offset the impact of an increase in asset variance on the option value of debt. I derive CS_POR for the Merton (1974) model of capital structure and use it in an empirical setting to explain variations in the spreads of (i) corporate bonds and (ii) credit default swaps. My measure clearly outperforms its benchmark and even beats predictors from a powerful reduced-form model.