The predictive power of structural models of corporate debt pricing

This paper tests empirically the performance of three structural models of corporate bond pricing: those of Merton (1974), Leland (1994) and Fan and Sundaresan (2000). We show that both Merton and Leland models overestimate bond prices while Fan and Sundaresan reveals an extremely good performance. When considering the prediction of credit spreads, the three models underestimate market spreads but, again, Fan and Sundaresan has a better performance. We find a rating, maturity, asset volatility and sector effect in the prediction power, as the models underestimate less the spreads of riskier firms and of bonds with better rating quality and longer maturity. Moreover, we find that spread errors are systematically related with some bond and firm’s specific variables, as well as term structure variables. Finally, an econometric model developed for equityholders bargaining power shows that it depends on proportional liquidation costs, firm’s size and distance to default.N/