Incorporating theDynamics of Leverageinto Default Prediction

A firm’s current leverage ratio is one of the core characteristicsof credit quality used in statistical default prediction models. Based on thecapital structure literature, which shows that leverage is mean-reverting to atarget leverage, we forecast future leverage ratios and include them in the setof default risk drivers. The analysis is done with a discrete duration model.Out-of-sample analysis of default events two to five years ahead reveals thatthe discriminating power of the duration model increases substantially whenleverage forecasts are included. We further document that credit ratingscontain information beyond the one contained in standard variables but thatthis information is unrelated to forecasts of leverage ratios.