This article proposes and estimates a tractable, arbitrage-free valuation model for corporate coupon bonds that includes a more realistic recovery rate process. Most existing studies use a recovery rate process that is misspecified because it includes recovery for coupons due after default. Misspecification errors from assuming recovery on all coupons can be substantial; they increase with recovery rates, coupons, maturity, and default probabilities. For a large sample of market transactions, i) our model has lower pricing errors than one assuming recovery on all coupons and ii) the magnitude of our model’s outperformance is linked to misspecification errors from assuming recovery on coupons.

This article provides evidence that equity returns lead credit protection returns at daily and weekly frequencies, whereas credit protection returns do not lead equity returns. Our results indicate that informed traders are primarily active in the equity market rather than the credit default swap (CDS) market. These findings are consistent with standard theories of market selection by informed traders in which market selection is determined partially by transaction costs. We also find that credit protection returns respond more quickly during salient news events (earnings announcements) compared to days with similar equity returns and turnover. This evidence provides support for explanations related to investor inattention.