A Structural Model for Optimal Selection of Maturity and Timing of Callable Bond Issuance

Abstract

A major shortcoming of previous structural models for bonds is that they ignore how the complex terms of a call feature interact with default to determine term structures at issuance. A term structure of par coupon yields is different from and superior to a term structure based on the option-adjusted spread and, furthermore, is the most useful term structure for firms issuing bonds because it is the most accurate measure of the cost of debt. The authors present a par coupon structural model that can be used as an aid in timing bond issues because some parameters of the model have been proven to exhibit predictability. One can use the model to incorporate the impact of alternative future Federal Reserve policies for short-term interest rates upon the optimal timing and maturity of corporate bond issuance. The authors report that par coupon term structures can have shapes distinctly different from other simultaneous term structures, such as those derived from option-adjusted spreads where the difference depends on default risk, alternative call features, and the interaction of default risk and call features. As one finding among many, they find that call option value (at issuance) declines as credit quality declines.