What Risks Do Corporate Bond Put Features Insure Against?
43 Pages Posted: 16 Mar 2007 Last revised: 16 Oct 2008
Date Written: October 1, 2008
Corporate bond prices are known to be influenced by default and term structure risk in addition to non-default risks such as illiquidity. Putable corporate bonds allow investors to sell their holdings back to the issuer and may thus provide insurance against all of these risks. We first document empirically that embedded put option values are related to proxies for all three. In a second step, we develop a valuation model that simultaneously captures default and interest rate risk. We use this model to disentangle the reduction in yield spread enjoyed by putable bonds that can be attributed to each risk. Perhaps surprisingly, the most important reduction is due to mitigated default or spread risk, followed by term structure risk. The reduction in the non-default component is present but rather small.
Keywords: Putable Bonds, Credit Risk, Liquidity Premium, Bivariate Lattice
JEL Classification: G13, G12
Suggested Citation: Suggested Citation