Testing for the Elasticity of Corporate Yield Spreads
Jonathan A. Batten
Hong Kong University of Science & Technology (HKUST) - Department of Finance
University of Manitoba - Department of Accounting and Finance; Seton Hall University
Rose C. Liao
Rutgers University, Newark, School of Business-Newark, Department of Finance & Economics
March 1, 2007
HKUST Business School Research Paper No. 07-03
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, G15working papers series
Date posted: March 2, 2007
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