Testing the Elasticity of Corporate Yield Spreads

Gady Jacoby, Rose C. Liao and Jonathan Batten

Journal of Financial and Quantitative Analysis, 2009, vol. 44, issue 3, 641-656

Abstract: 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.

Date: 2009
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