Risk-Free Interest Rates, the Call Feature, and Corporate Bond Yield Spreads

This paper provides an explanation for the negative relation between corporate bond yield spreads and risk-free interest rates, documented by Longstaff & Schwartz (1995) and Duffee (1998). The model also explains the effects of the call feature and bond risk (or rating) on the yield spread-interest rate relationship; it shows that (i) the call feature should generally strengthen the negative relationship, but should weaken it for low-grade bonds; and (ii) as bond quality declines, the sensitivity of non-callable yield spreads to interest rates should increase monotonically, while sensitivity of callable yield spreads should first fall slightly and then rise. While these effects have been empirically documented in Duffee (1998), they have not been completely explained as yet. Finally, the model implies that the yield spread-interest rate relationship should be significantly weaker for bonds issued by the banking/financial sector. This implication is supported by empirical tests carried out with corporate bond yield data.