A Pure Test for the Elasticity of Yield Spreads

Note that these maturities represent the maturity of the last Canadian corporate bonds issued
with a standard call provision prior to 1987. Thus, four years or so later, the “average'” bond,
issued originally with a standard call provision, is expected to become a medium-term bond,
with maturity below ten years. Since these are averages, to be safe, we feel that it is
reasonable to wait eight years instead, and to assert that starting 01:1995, the vast majority of
bonds included in SCM's long-term bond indices carry a doomsday call rather than a
standard call provision.

Following the above discussion, we conclude that SCM's long-term bond indices are
the indices suitable for our study, and thus we discard the mid-term and short-term indices.
Furthermore, we conclude that the 01:1995-07:2001 period, in which these long-term indices
consist mainly of bonds carrying a doomsday call, is an adequate estimation period to
control for the callability of the BBB-rated index.

In summary, analyzing yield spreads using the SCM Canadian corporate bond indices
has the advantage of controlling for callability and effects arising from taxation. Such an
analysis provides a clearer picture of the role of the default-risk adjustment in measuring the
sensitivity of investment-grade bond yield spreads to changes in the riskless rate.

4. Data and Method

4.1. Data

Our sample is based on month-end yield-to-maturity data from the Scotia Capital
Markets (SCM) investment-grade Canadian corporate bond indices, reported by Statistics
Canada (CANSIM). This index does not enable an accurate assessment to be made of
outstandings or trading volume for use as a proxy for liquidity. The SCM corporate bond
indices are stratified into four different investment-grade rating categories: AAA, AA, A, and
BBB. In this study, we use SCM's long-term corporate bond indices (motivated in section 1
for callability control), reported for the 08:1976-07:2001 25-year period. Data for the AAA
index are available only until March 1993, as no bonds fit this category for the later period.

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