Stock Market Performance andthe Term Structure of Credit Spreads

We build a two-factor structural model of default where the stock market index is one of the stochastic factors. In the model, we allow the firm to adjust its leverage in response to changes in the firm value and changes in the business climate, for which the return of the stock market index acts as a proxy. We assume that the firm's log-leverage ratio follows a mean-reverting process and that the past performance of the stock index negatively affects the firm's target leverage ratio. Our model shows that the past performance of the stock index returns and the correlation between the firm.s assets and index returns have a substantial impact on credit spreads. Hence, our model can explain why credit spreads may be di.erent within the same credit-rating groups and why spreads are lower during economic expansions and higher during recessions. We also show that our model may explain actual yield spreads better than other well known structural credit risk models.