Merton model has provided a classic theoretical framework for forecasting credit spreads. This paper extends Merton model by introducing morphology factor of asset value volatility in the model, and conducts empirical studies on the effect of volatility morphology factor on credit spreads in China’s bond market both at the bond index level and the individual bond level, indicating that volatility morphology factor is economically important and is key in allowing the extended model to explain credit spreads. Furthermore, this paper analyzes the asymmetric influences of monetary policy both on credit spreads and volatility morphology factor, and points out that the responses of credit spreads and asset volatility morphology to the impacts of monetary policy is consistent in the capital-strapped environments. To this end, monetary policy and liquidity, which are two factors that have been ignored by classic Merton model but proved to have significant influences on credit spreads, play a role in influencing credit spreads by changing the volatility morphology of asset value. Since volatility morphology can reflect the change of investors’ expectation on the asset’s default probability, the argument mentioned in the credit-spread puzzle that the fundamentals related to bond defaults cannot explain credit spreads needs to be reexamined.

Bond market, Credit spread puzzle, Merton model, Monetary policy, Volatility morphology