This paper presentsa methodology for extracting credit pricing information from the prices of callable corporate debt. Until recently, empirical research on corporate bond pricing has avoidedadirect treatment of callable corporate bonds. In practice, however, callable debt is popular. As of April 2003, the Fixed Investment Securities Database (FISD (2002)) contained a total of about 23,950 fixed-rate U.S. corporate debentures, of which roughly 60%in number and 42%in offering amount were callable. In order to extract credit-quality information from yield spreads, one must treat the simultaneous effects of credit risk and optionality.
Figure 1shows market prices ofa Baa3-rated callable bond issued by Occidental over the time period from January 1990 through December 1995. Also plotted are the prices at which this bond would trade if it was noncallable and default-free. The reduction in price of the actual callable, defaultablebond relative toits noncallable, default-free equivalent is due to two factors: discounting for default risk, andcallablity.
The primary objective of my work is to disentangle these two components, thus identifying the values of both the embedded American call option and the noncallable (defaultable) bond. In practice, the problem of valuing the call option is often approached with a term-structure model of the default-free yields, possibly adjusted for default risk by adding yield spreads of noncallable bonds (see, for example, Fan, Haubrich, Ritchken, and Thomson (2003)).
This method, however, reflectsa somewhat superficial point of view, because the market value of the call option depends not only on uncertainty regarding market interest rates, but also on the risk of changes in the credit quality of the bond. For example, an upgrade in credit quality of the callable Occidental bond, holding default-free yields constant, would increase the value of the embedded call option. The challenge when estimating the term structure of callable corporate bond yield spreads stems from this interaction between call-free credit spreads and the prices of the call option, which calls fora simultaneous solution of both.
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Estimating the Term Structure of Yield Spreads from Callable Corporate Bond Price Data
