A Pure Test for the Elasticity of Yield Spreads
1. Introduction
Structural models1 for the valuation of corporate bonds assume an asset-based default
process with default occurring once the stochastic value of the firm’s assets hits a default
threshold. In these models the threshold is conveniently expressed as the relation between
the market value of the firm's assets to its debt. One of the more notable predictions of
structural models is that credit spreads -the bond yield spread between a risky bond and a
near maturity riskless bond- are negatively correlated to the return on risky assets and
changes in default-free interest rates, with the former generally proxied by the return on a
well-diversified market index, while the later is proxied by the change in a near maturity
Government bond rate.
The objective of this paper is to once again revisit the theme of the pricing of corporate
credit spreads. There are two important grounds for doing so. First, despite extensive
empirical examination the expected negative correlations predicted by the structural models
are not necessarily present in risky bonds of all credit classes, maturities and markets (e.g.
Longstaff and Schwartz, 1995; Duffee, 1998; and Collin-Dufresne et al., 2001). Second,
more recent theoretical papers have questioned the underlying assumptions of the simple
structural models which lead to these conclusions (e.g. Duffee, 1998; Elton et al. 2001;
Campbell and Taksler, 2003; Ericsson and Renault, forthcoming).
The view that credit spreads are negatively related to asset returns is consistent with the
stylized facts evident in the pricing of risky bonds by market participants: credit spreads are
higher for bonds of declining credit quality; they increase when news negatively affects
underlying corporate asset values and when there is a lack of liquidity. The other conclusion
- of a negative relation to the riskless rate - is, however, not so apparent and has remained
the subject of extensive empirical verification. Ceteris paribus, under risk-neutral valuation,
an increase in the riskless rate implies a higher expected future value for the firm's assets
relative to the default threshold, and a lower risk-neutral probability of default. This