Equity volatility and credit yield spreads ∗

We show that a simple structural model of credit risk is able to generate credit yield spreads for the low-rated bonds close to the historical spreads once the recent trends in the stock volatility are taken into account. We study the idiosyncratic and market volatility of stock returns in the cross-section of credit ratings. We find that the increase in the level of the firm-specific volatility, demonstrated recently by Campbell et al. (2001), refers only to the low-rated stocks. A time-varying deterministic volatility process is used to imply the asset volatilities, the asset risk premia and the default boundaries from the historical default rates. Stock volatility is modeled as an autoregressive process. Physical default probability of an investment-grade bond is primarily linked to the drift of the firm value process and default probability of a low-rated bond to the total asset volatility. We confirm this by finding that an increase in the firm-specific volatility affects credit spreads of the low-rated bonds and does not have an observable impact on the investment-grade bonds. ∗I wish to thank Pierre Collin-Dufresne, Greg Duffee, Kay Giesecke and Haas School of Business finance Ph.D. student seminar participants for valuable comments. †Walter A. Haas School of Business, University of California at Berkeley, Berkeley, CA 94720; [email protected].