Determinants of the ratings and yields on corporate bonds: tests of the contingent claims model

A contingent claims model for corporate bonds is tested on newly issued bonds of firms with very simple capital structures. Two default risk measures derived from the model – firm return standard deviation (σ) and leverage (D/V) – explain approximately 78 percent of the variation in the agency ratings on the bonds, based on a probit analysis. Model yield premiums explain almost 60 percent of the variation in market yield premiums. In both analyses, however, firm size is a significant additional variable, suggesting that the contingent claims model is not robust to changes in scale. The assumption of nonstochastic interest rates also appears to be an important misspecification. Institutional restrictions on investments in speculative grade bonds, however, do not affect market yield premiums on such bonds, and thus do not appear to represent a serious misspecification.