A Pure Test for the Elasticity of Yield Spreads

matching maturity) plus a spread (the doomsday spread).⁶ Thus, a make-whole call price is
calculated in the same manner as that of the doomsday call, but the bond’s remaining cash
flows are discounted with the yield of comparable maturity treasury security plus a
contractually specified “make-whole premium”.

Below, we demonstrate that BBB-rated Canadian bonds are always traded with yield
spreads much wider than the doomsday spread set in their call provision. Thus, the exercise
of the doomsday call for BBB-rated bonds will rarely cause financial damage to the
bondholders, and these bonds may be considered economically noncallable.⁷

To substantiate this feature of Canadian corporate bonds, we collect doomsday
spreads for all bonds carrying the doomsday call for each month during the 01:1993-12:1999
period, from the Financial Post Corporate Bond Record. Since in this study we focus on
SCM's long-term bond indices, we limit our sample to data corresponding to bonds with a
maturity greater than ten years. We stratify our data by credit rating, and for every month, we
calculate the average and standard deviation of doomsday spreads across bonds within each
rating category. Since data for the AAA bonds are unavailable for most of the sample period,
we obtain statistics only for AA, A, and BBB rated bonds.

To determine the moneyness of the doomsday call provision, one must compare the
doomsday spread to the yield spread. In Figure 1, for each rating category, we plot the yield
spread on the corresponding long-term index (5), the average doomsday spread (μ), the
average doomsday spread plus one standard deviation (μ+σ), and the average doomsday
spread plus two standard deviations (μ+ 2σ).8 In Panel A of Figure 1, we see that for AA-
rated bonds the yield spread is lower than the average doomsday spread in a large number of
cases, and it is almost always lower than the doomsday spread plus one standard deviation.
Similarly, in Panel B of Figure 1 we see that the yield spread of A-rated bonds is often lower
than the average doomsday spread, and in a significant number of cases it is lower than the
doomsday spread plus one standard deviation.

Based on this 7-year sample it is clear that the probability of the doomsday call being

10

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