Testing the Elasticity of Corporate Yield Spreads

What drives the compensation demanded by investors in risky bonds? Longstaff and Schwartz (1995) predict that one key factor is the time-varying negative correlation between interest rates and the yield spreads on corporate bonds. However, the effects of callability and taxes also need to be conside...

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Bibliographic Details
Published in:Journal of financial and quantitative analysis 2009-06, Vol.44 (3), p.641-656
Main Authors: Jacoby, Gady, Liao, Rose C., Batten, Jonathan A.
Format: Article
Language:English
Subjects:
Bond issues
Bond market
Call options
Capital returns
Compensation
Corporate bonds
Corporate taxes
Correlation
Default
Financial instruments
Government bonds
Interest rates
Quantitative analysis
Risk exposure
Spread
Taxable bonds
Taxation
U.S.A
Yield
Yield curves
Yield to maturity
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Summary:What drives the compensation demanded by investors in risky bonds? Longstaff and Schwartz (1995) predict that one key factor is the time-varying negative correlation between interest rates and the yield spreads on corporate bonds. However, the effects of callability and taxes also need to be considered in empirical analyses. Canadian bonds have no tax effects, yet, after controlling for callability, the correlation between riskless interest rates and corporate bond spreads remains negligible. Our results 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.
ISSN:0022-1090
1756-6916
DOI:10.1017/S002210900999007X