A Pure Test for the Elasticity of Yield Spreads



A Pure Test for the Elasticity of Yield Spreads

Abstract

The correlation between interest rates and corporate bond yield spreads is a well-known
feature of structural bond pricing models. Duffee (1998) argues that this correlation is weak
once the effects of call options are removed from the data; a conclusion that contradicts the
negative correlation expected by Longstaff and Schwartz (1995). However, Elton et al. (2001)
point out that Duffee’s analysis ignores the effects of the tax differential between U.S.
Treasury and corporate bonds. Canadian bonds have no such tax differential, yet, after
controlling for callability, we find that the correlation between interest rates and corporate
bond spreads remains negligible. We also find a significant negative relationship for callable
bonds with this relationship increasing with the moneyness of the call provision. These
results are robust under alternate empirical specifications.



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