IDEAS home Printed from
   My bibliography  Save this paper

Bond Prices, Yield Spreads, and Optimal Capital Structure with Default Risk


  • Hayne Leland.


This paper examines the value of debt subject to default risk in a continuous time framework. By considering debt with regular principal repayments (e.g. through a sinking fund), we are able to examine bonds with arbitrary maturity while retaining a time-homogeneous environment. This extends Leland's [1994] earlier closed-form results to a much richer class of possible debt structures. We examine the term structure of yield spreads and find that a rise in interest rates will reduce yield spreads of current debt issues. It may tilt the term structure as well. Duration is also affected by default risk. The traditional Macaulay duration measure overstates effective duration, which for junk bonds may even be negative. While short term debt does not exploit tax benefits as completely as does long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. The agency costs of asset substitution are minimized when firms use shorter term debt. Optimal capital structure depends upon debt maturity. Optimal leverage ratios are smaller, and maximal firm values are less, when short term debt is used. The yield spread at the optimal leverage ratio increases with debt maturity.

Suggested Citation

  • Hayne Leland., 1994. "Bond Prices, Yield Spreads, and Optimal Capital Structure with Default Risk," Research Program in Finance Working Papers RPF-240, University of California at Berkeley.
  • Handle: RePEc:ucb:calbrf:rpf-240

    Download full text from publisher

    To our knowledge, this item is not available for download. To find whether it is available, there are three options:
    1. Check below whether another version of this item is available online.
    2. Check on the provider's web page whether it is in fact available.
    3. Perform a search for a similarly titled item that would be available.


    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.

    Cited by:

    1. Gordian Rättich & Kim Clark & Evi Hartmann, 2011. "Performance measurement and antecedents of early internationalizing firms: A systematic assessment," Working Papers 0031, College of Business, University of Texas at San Antonio.
    2. Décamps, Jean-Paul & Villeneuve, Stéphane, 2009. "Rethinking Dynamic Capital Structure Models with Roll-Over Debt," IDEI Working Papers 528, Institut d'Économie Industrielle (IDEI), Toulouse, revised Nov 2011.
    3. repec:eee:macchp:v2-1697 is not listed on IDEAS
    4. Chernov, Mikhail & Schmid, Lukas & Schneider, Andres, 2016. "A Macrofinance View of U.S. Sovereign CDS Premiums," CEPR Discussion Papers 11576, C.E.P.R. Discussion Papers.
    5. Marco Realdon, "undated". "Convertible Subordinated Debt Valuation and "Conversion in Distress"," Discussion Papers 03/18, Department of Economics, University of York.
    6. Karan Bhanot & Donald Lien & Margot Quijano, 2008. "Will Pulling Out the Rug Help? Uncertainty about Fannie and Freddie’s Federal Guarantee and the Cost of the Subsidy," Working Papers 0035, College of Business, University of Texas at San Antonio.
    7. Hugonnier, Julien & Malamud, Semyon & Morellec, Erwan, 2015. "Credit market frictions and capital structure dynamics," Journal of Economic Theory, Elsevier, vol. 157(C), pages 1130-1158.
    8. Jean-Paul Décamps & Stéphane Villeneuve, 2014. "Rethinking Dynamic Capital Structure Models With Roll-Over Debt," Mathematical Finance, Wiley Blackwell, vol. 24(1), pages 66-96, January.
    9. Aguiar, Mark & Amador, Manuel, 2018. "Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models," Staff Report 565, Federal Reserve Bank of Minneapolis.
    10. Hainaut, Donatien, 2015. "Evaluation and default time for companies with uncertain cash flows," Insurance: Mathematics and Economics, Elsevier, vol. 61(C), pages 276-285.
    11. Alina Sima (Grigore) & Alin Sima, 2011. "Distance to Default Estimates for Romanian Listed Companies," The Review of Finance and Banking, Academia de Studii Economice din Bucuresti, Romania / Facultatea de Finante, Asigurari, Banci si Burse de Valori / Catedra de Finante, vol. 3(2), pages 091-106, December.
    12. N. Letifi & J.-L. Prigent, 2014. "On the debt capacity of growth and decay options," Working Papers 2014-391, Department of Research, Ipag Business School.
    13. Perrakis, Stylianos & Zhong, Rui, 2015. "Credit spreads and state-dependent volatility: Theory and empirical evidence," Journal of Banking & Finance, Elsevier, vol. 55(C), pages 215-231.
    14. Marco Realdon, "undated". "Valuation of Put Options on Leveraged Equity," Discussion Papers 03/19, Department of Economics, University of York.
    15. repec:ipg:wpaper:2014-331 is not listed on IDEAS
    16. Zhiguo He & Konstantin Milbradt, 2016. "Dynamic Debt Maturity," Review of Financial Studies, Society for Financial Studies, vol. 29(10), pages 2677-2736.
    17. Aguiar, M. & Chatterjee, S. & Cole, H. & Stangebye, Z., 2016. "Quantitative Models of Sovereign Debt Crises," Handbook of Macroeconomics, Elsevier.
    18. Joachim Jungherr & Immo Schott, 2016. "Optimal Debt Maturity and Firm Investment," Working Papers 943, Barcelona Graduate School of Economics.
    19. Bhanot, Karan & Mello, Antonio S., 2006. "Should corporate debt include a rating trigger?," Journal of Financial Economics, Elsevier, vol. 79(1), pages 69-98, January.

    More about this item


    Access and download statistics


    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ucb:calbrf:rpf-240. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum). General contact details of provider: .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.