Credit spreads and capital structure policy

What is the effect of capital structure policy on credit spreads? In a widely cited paper by Huang and Huang (2003), a few representative structural models of credit spreads have been calibrated and compared. Among them are the model by Collin-Dufresne and Goldstein (2001) and the one by Leland and Toft (1996). The former assumes exogenously given stationary mean-reverting leverage, the latter optimizes its capital structure endogenously. Their study shows that all the models they calibrated perform similarly in that they all explain a very small portion of the observed spreads. We make three improvements based on that study. First, we correct a mistake in their calibration for the CG model. Second, the Leland (1994) model of perpetual bond was used for simplicity. We strictly calibrate the LT model with finite maturities. Third, we use the same set of targets, so the model comparison is more meaningful. We argue that leverage ratio cannot be an appropriate target for calibrating the Leland-Toft model. This differentiates our calibration approaches. All these three issues have not been recognized thus far and we address them in this paper.