A Simple Multi-Factor Model of Corporate Bond Prices

Abstract

We propose a multi-factor structural model of corporate bond prices. Bonds are valued in an arbitrage-free setting. The term structure of credit spreads is a function of a set of observable variables, including the issuer's leverage ratio, the riskfree interest rate and other stochastic factors that proxy for the issuer's likelihood of default. The set of factors may include both systematic and idiosyncratic components. We test the model using prices of Delta Airlines' bonds. Factors included in this empirical analysis are the growth rate of GDP and the volatility on Delta's stock. The root mean squared error between actual credit spreads and model-determined credit spreads decreases from 45 to 40 basis points when these factors are included in the analysis. Several extant models in the literature are special cases of the structure developed here and rejected in the empirical work.