The relation between treasury yields and corporate bond yield spreads

Abstract

Because the option to call a corporate bond should rise in value when bond yields fall, the relation between noncallable Treasury yields and spreads of corporate bond yields over Treasury yields should depend on the callability of the corporate bond. I confirm this hypothesis for investment-grade corporate bonds. Although yield spreads on both callable and noncallable corporate bonds fall when Treasury yields rise, this relation is much stronger for callable bonds. This result has important implications for interpreting the behavior of yields on commonly used corporate bond indexes, which are composed primarily of callable bonds. COMMONLY USED INDEXES OF CORPORATE bond yields, such as those produced by Moody’s or Lehman Brothers, are constructed using both callable and noncallable bonds. Because the objective of those producing the indexes is to track the universe of corporate bonds, this methodology is sensible. Until the mid-1980s, few corporations issued noncallable bonds, hence an index designed to measure the yield on a typical corporate bond would have to b