Term Structures of Credit Spreads with Incomplete Accounting Information

We study the implications of imperfect information for term structures of credit spreads on corporate bonds. We suppose that bond investors cannot observe the issuer’s assets directly, and receive instead only periodic and imperfect accounting reports. For a setting in which the assets of the firm are a geometric Brownian motion until informed equityholders optimally liquidate, we derive the conditional distribution of the assets, given accounting data and survivorship. Contrary to the perfect-information case, there exists a default-arrival intensity process. That intensity is calculated in terms of the conditional distribution of assets. Credit yield spreads are characterized in terms of accounting information. Generalizations are provided. We are exceptionally grateful to Michael Harrison for his significant contributions to this paper, which are noted within. We are also grateful for insightful research assistance from Nicolae Gârleanu, Mark Garmaise, and Jun Liu; for very helpful discussions with Martin Jacobsen, Marliese Uhrig-Homburg, Marc Yor, and Josef Zechner; and for comments from Michael Roberts, Klaus Toft, William Perraudin, Monique Jeanblanc, Jean Jacod, Philip Protter, Alain Sznitmann, Emmanuel Gobet, Anthony Neuberger, Jason Wei, Pierre de la Noue, Olivier Scaillet, numerous seminar participants, as well as Drew Fudenberg and several anonymous referees. Duffie is at GSB Stanford CA 94305-5015 (Phone: 650-723-1976; Fax: 650-725-7979; Email: [email protected]), and was supported in part by the Financial Research Initiative and the Gifford Fong Associates Fund at The Graduate School of Business, Stanford University. We are also grateful for hospitality from the Institut de Finance, Université de Paris, Dauphine, and the Financial Markets Group of the London School of Economics. Lando is at the University of Copenhagen, Department of Operations Research, Universitetsparken 5, DK-2100 Copenhagen O, Denmark, and was supported in part by The Danish Natural and Social Science Research Councils. (Phone: +45 35 32 06 83; Fax: +45 35 32 06 78; Email: [email protected]). This paper can be downloaded in postscript form at http://www.stanford.edu/∼duffie/ or http://www.math.ku.dk/∼dlando/.