| This thesis addresses two puzzles about corporate debt: the "credit spread puzzle"---why yield spreads between corporate bonds and treasuries are high and volatile---and the "under-leverage puzzle"---why firms use debt conservatively despite seemingly large tax benefits and low costs of financial distress. I propose a unified explanation for both puzzles: investors demand high risk premia for holding defaultable claims, including corporate bonds and levered firms, because (i) defaults tend to concentrate in bad times when marginal utility is high; (ii) default losses are also higher during such times. I study these comovements in a structural model, which endogenizes firms' financing and default decisions in an economy with business-cycle variation in expected growth rates and economic uncertainty. These dynamics coupled with recursive preferences generate countercyclical variation in risk prices, default probabilities, and default losses. The credit risk premia in my calibrated model are large enough to account for most of the high spreads and low leverage ratios. Relative to a standard structural model without business-cycle variation, the average spread between Baa and Aaa-rated bonds rises from 48 bp to around 100 bp, while the average optimal leverage ratio of a Baa-rated firm drops from 67% to 42%, both close to the U.S. data. |
