Predictions of Default Probabilities in Structural Models of Debt

We examine the default probabilities predicted by “structural” models of risky corporate debt. Two types of models are examined: those with “exogenous” default boundaries, typified by Longstaff and Schwartz (1995); and those with “endogenous” default boundaries, typified by Leland and Toft (1996). We focus on default probabilities rather than credit spreads because (i) they are not affected by additional factors such as liquidity, tax differences, and recovery rates; and (ii) prediction of the relative likelihood of default is often stated as the objective of bond ratings. We examine the ability of these models to capture the actual average default frequencies across bonds with different ratings reported in Moody’s (2001) corporate bond default data, 1970-2000.