A Pure Test for the Elasticity of Yield Spreads

relationship between the yield premium attributed to callability and the riskless rate. Instead,
Duffee uses noncallable bond portfolios and finds that the negative yield spread - riskless
rate relation is much weaker once callability is controlled. Elton et al. (2001), point out that
Duffee’s (1998) analysis ignores the effects of state taxes on U.S. bonds, and they argue that
differential taxes on corporate and government bonds have an important impact on corporate
bond yield spreads.

Canadian corporate bond indices are devoid of tax effects since Canadian corporate and
government bonds, unlike U.S. bonds, are subject to the same tax treatment. These indices
also contain a call provision that allows for identifying callable and economically
noncallable bonds. Using this Canadian bond index data, we find an insignificant yield
spread - government yield relation for economically noncallable bonds. For bonds with an
economically viable call option, the negative relation we find increases with the moneyness
of the call option. Our tests of different models with both real interest rates and nominal
interest rates, with both yield spread and real (expected) default rates, consistently show the
robustness of our results. We conclude that call risk dominates the negative yield spread -
government yield relation. We further conclude that, for investment-grade bonds, the role of
the asset factor (manifesting default risk) in influencing the sensitivity of corporate bond
yield spreads to government yields is not significant.

These results indicate that a gap remains in our understanding of the default process.
Theoretically, structural models suggest that an increase in the riskless rate implies a higher
expected future value for the firm’s asset relative to the default threshold, and a lower risk-
neutral probability of default and risk neutral credit spread. Empirically, we show that
bondholders do not adjust their required default premium for an increase in the riskless rate.
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.

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