Incomplete Information, Debt Issuance, and the Term Structure of Credit Spreads

Abstract

We propose a tractable bond pricing model in which managers have an informational advantage over creditors. We show that, regardless of how poor their private signal is, managers of firms that can access the credit market will avoid default by issuing new debt to service existing debt. Therefore, only bonds of firms that have exhausted their ability to borrow are subject to jump-to-default risk due to incomplete information and, in turn, command a jump-to-default risk premium. We document that our model captures many salient features of the corporate bond market.

Keywords: Bond pricing; Credit spreads; Jumps to Default

JEL Classification: G12, G32, G33