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A Pure Test for the Elasticity of Yield Spreads

  • Gady Jacoby
  • Chuan Liao
  • Jonathan A. Batten

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, we find that the correlation between interest rates and corporate bond spreads remains negligible. We also find a significant negative relationship for callable bonds with this relationship increasing with the moneyness of the call provision. These results are robust under alternate empirical specifications.

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Paper provided by IIIS in its series The Institute for International Integration Studies Discussion Paper Series with number iiisdp195.

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Date of creation: 05 Jan 2007
Date of revision:
Handle: RePEc:iis:dispap:iiisdp195
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  1. John Y. Campbell & Glen B. Taksler, 2002. "Equity Volatility and Corporate Bond Yields," Harvard Institute of Economic Research Working Papers 1945, Harvard - Institute of Economic Research.
  2. Dirk Hackbarth & Jianjun Miao & Erwan Morellec, 2004. "Capital Structure, Credit Risk, and Macroeconomic Conditions," FAME Research Paper Series rp125, International Center for Financial Asset Management and Engineering.
  3. Jan Ericsson & Olivier Renault, 2006. "Liquidity and Credit Risk," Journal of Finance, American Finance Association, vol. 61(5), pages 2219-2250, October.
  4. Hayne E. Leland., 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Research Program in Finance Working Papers RPF-233, University of California at Berkeley.
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  7. Sanjiv Ranjan Das & Rangarajan K. Sundaram, 2000. "A Discrete-Time Approach to Arbitrage-Free Pricing of Credit Derivatives," Management Science, INFORMS, vol. 46(1), pages 46-62, January.
  8. Kamara, Avraham, 1997. " The Relation between Default-Free Interest Rates and Expected Economic Growth Is Stronger Than You Think," Journal of Finance, American Finance Association, vol. 52(4), pages 1681-94, September.
  9. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  10. Bodie, Zvi & Taggart, Robert A, Jr, 1978. "Future Investment Opportunities and the Value of the Call Provision on a Bond," Journal of Finance, American Finance Association, vol. 33(4), pages 1187-1200, September.
  11. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, vol. 53(6), pages 2225-2241, December.
  12. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  13. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 37-68.
  14. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  15. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
  16. Jordan, Bradford D. & Jordan, Susan D., 1991. "Tax options and the pricing of treasury bond triplets : Theory and evidence," Journal of Financial Economics, Elsevier, vol. 30(1), pages 135-164, November.
  17. Campbell R. Harvey, 1997. "The Relation between the Term Structure of Interest Rates and Canadian Economic Growth," Canadian Journal of Economics, Canadian Economics Association, vol. 30(1), pages 169-93, February.
  18. Jonathan Batten & Warren Hogan & Gady Jacoby, 2005. "Measuring credit spreads: evidence from Australian Eurobonds," Applied Financial Economics, Taylor & Francis Journals, vol. 15(9), pages 651-666.
  19. Prisman, Eliezer Z. & Roberts, Gordon S. & Tian, Yisong, 1996. "Optimal bond trading and the tax-timing option in Canada," Journal of Banking & Finance, Elsevier, vol. 20(8), pages 1351-1363, September.
  20. Long Chen & David A. Lesmond & Jason Wei, 2007. "Corporate Yield Spreads and Bond Liquidity," Journal of Finance, American Finance Association, vol. 62(1), pages 119-149, 02.
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  22. Jacoby, Gady & Roberts, Gordon S., 2003. "Default- and call-adjusted duration for corporate bonds," Journal of Banking & Finance, Elsevier, vol. 27(12), pages 2297-2321, December.
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