Corporate Bond Pricing and the Effects of Endogenous Default and Call Options

Abstract

Recent structural models for valuing callable corporate bonds show that both callability and default options have important implications for the interest-rate sensitivity of yield spreads and the bond duration. Special attention is given to the interaction between the two risks. In this article, the authors test the main implications of these models. Specifically, they examine the interest-rate elasticity of the call spread and that of the default spread, allowing for interaction between both spreads. Furthermore, they examine the impact of both risks and their interaction on the effective duration of corporate bonds. They also test theoretical predictions regarding corporate bond sensitivity to firm value. Their findings support the predictions of the theory for bonds carrying a standard fixed-price call option and those carrying the newer make-whole option.