Analyzing Cost of Debt and Credit Spreads Using a Two Factor Model with Multiple Default Thresholds and Varying Covenant Protection

Abstract

The cost of debt capital for corporations depends on credit spreads. In this study, we will analyze the shape of credit spread term structures. The shape of credit spreads depends upon the shape of first passage default. Importantly, our work is the first to use a two factor model and also allow separation of (1) default probability due to breach of barrier versus (2) default probability due to assets being less than face value at maturity. We note that in some cases, first passage default has a hump but not in others. It is useful to see when and how first passage default humps may contribute to a humped credit spread. The impact of recently popular weak covenants is shown to play a major role in the shape of credit spreads. The implications of our study are important to such topics as measuring the riskiness of the banking system dependent upon credit spread slopes.