Testing for the Elasticity of Corporate Yield Spreads

Abstract:     
The correlation between interest rates and corporate bond yield spreads is a well-known feature of structural bond pricing models. Duffee (1998) argues that this correlation is weak once the effects of call options are removed from the data; a conclusion that contradicts the negative correlation expected by Longstaff and Schwartz (1995). However, Elton et al. (2001) point out that Duffee's analysis ignores the effects of the tax differential between U.S. Treasury and corporate bonds. Canadian bonds have no such tax differential, yet, after controlling for callability, the correlation between riskless interest rates and corporate bond spreads remains negligible. We also find a significant negative relationship for callable bonds that increases with the moneyness of the call provision. These results are robust under alternate empirical specifications. Our results therefore provide support for reduced-form models that explicitly define a default hazard process and untie the relation between the firm's asset value and default probability.

Number of Pages in PDF File: 51

Keywords: Bond Yield Spread, Default Risk, Callable Bonds, Corporate Bonds

JEL Classification: G11, G15

working papers series