A Pure Test for the Elasticity of Yield Spreads

***Insert Table 9 here***

Recall that forecasted default rates may serve as a better proxy for expected default
probabilities. In Panel B, we use Moody’s monthly speculative-grade default rate forecasts
and find similar results. The results for the U.S. data are similar to the results of the historical
default rates, except that now all coefficients are insignificant. Surprisingly, for the Canadian
data we find a positive and significant relation between default-rate forecasts and the riskless
rate. This is in contrast to the negative correlation found for the callable Canadian bond
indices, and the lack of a significant relation found for the noncallable indices.

The results in this section support our contention that the prediction of structural models
- a negative relation between the default probabilities (and credit spreads) and the riskless
rate - does not hold empirically. This is in contrast to the negative result found for yield
spreads in previous studies (see for example: Longstaff and Schwartz, 1995; Duffee, 1998;
and Collin-Dufresne et al., 2001). Our results are robust as, in contrast with yield spreads,
default rates serve as a more direct measure of credit risk since they are free of callability
and tax effects.

7. Summary and Conclusions

Longstaff and Schwartz (1995) provide a model for the valuation of corporate bonds,
which account for two stochastic factors, which accommodate the effects of interest-rates
and the firm's asset value. One of the most notable predictions of this and other structural
models with an asset-based default process is that credit spreads are negatively related to the
riskless rate. Longstaff and Schwartz test this prediction along with their predicted negative
impact of the asset factor on credit spreads using Moody’s indices and consider the negative
relationship they find as evidence supporting their model’s prediction.

Duffee (1998) argues that most of the bonds in Moody’s indices are callable bonds and
thus the negative yield spread - riskless rate relation could be largely due to the negative

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