Investment-Based Corporate Bond Pricing ∗

A standard assumption of structural models of default is that firms assets evolve exogenously. In this paper, we document the importance of accounting for investment options in models of credit risk. In the presence of financing and investment frictions, firm-level variables which proxy for asset composition carry explanatory power for credit spreads beyond leverage. As a result, cross-sectional studies of credit spreads that fail to control for the interdependence of leverage and investment decisions are unlikely to be very informative. Such frictions also give rise to a realistic term structure of credit spreads in a production economy