Predicting Bond Defaults

To predict the probability of default on their bond obligations, Daniel Rubinfeld studied a sample of 35 municipalities in Massachusetts for the year 1930, several of which did in fact default. The LPM model he chose and estimated was as follows12:

P= 1.96 — 0.029 TAX — 4.86 INT + 0.063 AV + 0.007 DAV — 0.48 WELF

(0.29) (0.009) (2.13) (0.028) (0.003) (0.88) (15.3.2)

Where P = 0 if the municipality defaulted and 1 otherwise, TAX = average of 1929, 1930, and 1931 tax rates: INT = percentage of current budget allocated to interest payments in 1930; AV = percentage growth in assessed property valuation from 1925 to 1930; DAV = ratio of total direct net debt to total assessed valuation in 1930; and WELF = percentage of 1930 budget allocated to charities, pensions, and soldiers' benefits.

The interpretation (15.3.2) is again fairly straightforward. Thus, other things being the same, an increase in the tax rate of $1 per thousand will raise the probability of default by about 0.03, or 3 percent. The R2 value is rather low but, as noted previously, in LPMs the R2 values generally tend to be lower and are of limited use in judging the goodness of fit of the model.

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