As part of the series of the "Finance Research Seminar", VGSF welcomes Lorenzo Garlappi from the Sauder School of Business to present his research paper.
The Term Structure of Credit Spreads with Dynamic Debt Issuance and Incomplete Information
We investigate credit spreads and capital structure dynamics in a model in which management has private information regarding firm value and is able to issue both equity and debt to service existing debt. Rather than choosing to default, managers of investment-grade (IG) firms who receive bad private signals conceal this information by servicing existing debt via new debt issuance. As such, firms with IG-commensurate spreads have zero jump-to-default risk (and hence, command zero jump-to-default premium), at least until their debt capacity is fully utilized and spreads have increased to “fallen angel” status. These predictions match observation well.