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1 July 2014 CFA Institute Journal Review

The Effect of Interest Rate Volatility and Equity Volatility on Corporate Bond Yield Spreads: A Comparison of Noncallables and Callables (Digest Summary)

  1. Lawrence Gillum, CFA

In their exploration of the impact of interest rate volatility and equity volatility on callable and noncallable yield spreads, the authors find that interest rate volatility is positively related to yield spreads but that the relationship is strongest for junk bonds. Additionally, the effect of interest rate volatility on yield spreads is smaller for callable bonds than for noncallable bonds.

What’s Inside?

The authors investigate the impact that interest rate volatility and equity volatility have on corporate bond yield spreads. In addition, they explore the effect of interest rate volatility on noncallable bond spreads versus the spread of bonds with embedded call options. Because greater interest rate volatility probably increases the volatility of a firm’s debt, a positive relationship exists between interest rate volatility and yield spread. The authors then investigate whether the positive effect of interest rate volatility on yield spreads is stronger or weaker for callable bonds and find that it is weaker, which indicates a negative relationship between default spreads and call spreads.

How Is This Research Useful to Practitioners?

Many practitioners are already familiar with the relationship between interest rate volatility and corporate bond spreads; some bond pricing theories suggest that interest rate volatility is priced into corporate bond spreads. The authors contend, however, that there is no empirical work to test the effects of these relationships. As such, their results support existing theory by providing actual results.

The authors’ research is helpful to practitioners who are involved in return enhancement processes or who hedge portfolios from adverse price movements. In terms of return enhancement, because interest rate volatility is demonstrated to be priced into the spreads between US Treasury bonds and corporate bonds, portfolio managers can develop strategies that include an optimal mix between US Treasuries and corporate bonds based on an expectation of interest rate volatility. That is, when interest rate volatility is predicted to increase, the spread also tends to increase. Thus, portfolio managers can reduce their holdings of corporate bonds relative to Treasuries in such situations. Likewise, hedging strategies that incorporate this relationship should provide improved hedging performance.

How Did the Authors Conduct This Research?

The authors use transaction data from 2003 to 2009 from Trade Reporting and Compliance Engine (TRACE) and include a sample of 134,167 different bond-month transactions for noncallable bonds and 88,273 different bond-month transactions for callable bonds. They define the interest rate volatility as the standard deviation of the daily one-month Treasury rate over the trailing 12-month period. For equity volatility, they obtain equity prices from CRSP and define equity volatility as the standard deviation of daily excess returns over the CRSP value-weighted index using 252 daily returns prior to the bond transaction date.

First, the authors examine time-series variations of interest rate volatility and yield spreads of noncallable bonds. They plot interest rate volatility and the mean yield spread of each month from 2003 to 2009. Using variables that include such characteristics as liquidity, maturity, and measures of financial strength, they regress the monthly observations for noncallable bonds and find that the yield spread is positively related to interest rate volatility and independent of bond-specific, issuer-specific, and macroeconomic variables. A similar regression is run on the full sample of bonds to determine the effect of interest rate volatility on yield spreads for bonds with call provisions.

Abstractor’s Viewpoint

By confirming existing theory, the authors provide support for the intuitive relationship between interest rate volatility and corporate bond spreads. That no prior empirical research supported this relationship is surprising. As such, the authors’ work will likely be an important contribution to the ongoing study of the markets. One can quibble that the analysis is conducted over a relatively short time period (seven years) and includes the extremely disruptive effects of the global financial crisis, but given the intuitive relationship that exists between volatility and risk in general, the results will likely hold up over various time horizons.

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