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**Theory and Empirical Evidence
**

Eric Powers∗and Sergey Tsyplakov Moore School of Business University of South Carolina Columbia, SC 29208 February 11, 2004

∗

Corresponding author. Tel +1-803-777-4928. E-mail address: epowers@moore.sc.edu. We thank Brent

Ambrose, Frank Fehle, Shingo Goto, Brad Jordan, Steve Mann, Sattar Mansi, Ted Moore, Greg Niehaus, Ellen Roueche, Stathis Tompaidis, and seminar participants at the University of South Carolina for helpful comments.

Are Make-Whole Call Provisions Overpriced? Theory and Empirical Evidence

Abstract We use a structural model to examine whether make-whole call provisions - a recent yet surprisingly common innovation in corporate debt markets - are fairly priced at origination. The call provision cost is calculated as the callable bond yield minus the equivalent noncallable bond yield, producing an incremental yield attributable to the make-whole call provision. Model parameters are calibrated to match characteristics of the issuing ﬁrm, bond, and yield curve at origination for a large sample of recently issued US corporate bonds. Our analysis indicates that while our model successfully captures cross-sectional variation in incrementals yields, observed values are signiﬁcantly greater than model-generated values. The discrepancy between model-generated and observed incremental yields persists even after we incorporate selected market imperfections that should widen incremental yields. Our conclusion is that make-whole call provisions at origination have been mispriced and that issuing ﬁrms have been paying too much for the ﬁnancial ﬂexibility that the call provision provides.

1

Introduction

It is well-known that there has been a decline in the prevalence of ﬁxed-price call provisions in US corporate bonds throughout the 1980s and 1990s (Brealey and Myers; 2003, p.708). What is less well-known is that a new type of call provision, known as a make-whole call, has recently supplanted ﬁxed-price call provisions. For example, in 2001, the amount of newlyissued corporate debt with make-whole call provisions was more than 30 percent greater than the amount of non-callable and ﬁxed-price callable corporate debt combined - see Figure 1 for the trend since 1995. With a make-whole call provision, the call price is not determined by a price schedule, rather, the call price ﬂoats inversely with Treasury rates. If exercised, the make-whole call price is calculated as the maximum of par value or the present value of the bond’s remaining payments. The discount rate used in the present value calculation is the comparable maturity Treasury yield plus a spread (known as the make-whole premium) that is speciﬁed in the bond’s indenture. Thus, as risk-free rates decrease, the call price increases. Conversely, as risk-free rates increase, the call price decreases until the ﬂoor at par is hit.1 The primary beneﬁt of make-whole call provision relative to a traditional ﬁxed-price call provision is that the ﬂoating call price virtually eliminates the incentive for the ﬁrm to call when interest rates drop. Thus, interest rate risk that bondholders are exposed to via the call option is signiﬁcantly reduced. With reduced risk, bondholders should demand less compensation for their short position in the option. The required compensation, i.e. the cost of the call option, is further limited by the fact that make-whole premiums are always set well below prevailing credit spreads. Since prices (both market and call) are inversely

For more detail on the characteristics and beneﬁts of make-whole call provisions, see Mann and Powers (2003b). Also see Emery, Hoﬀmeister, and Spahr (1987) who suggested indexing call prices well before make-whole call provisions became prevalent.

1

1

related to yields (risk-free rate plus credit spread or make-whole premium), this ensures that make-whole call options will be well out-of-the-money at origination. In our sample, for example, make-whole premiums average approximately 25 bp, but at-issue credit spreads of the associated bonds are 150 bp greater on average. In fact, most of these call provisions are unlikely ever to be in the money. Since January 1995 for example, the 10-year Aaa credit spread has never dipped below 32 bp, yet 79 percent of the make-whole premiums in our sample are less than this value.2 Furthermore, the call provision’s ﬂoor at par ensures that the call will always be out-of-the-money whenever the bond is trading at a discount. Our primary objective is to determine what is fair compensation for the short position held by make-whole call bond investors. Intuitively, the cost of the call provision should be low, but how low? Mann and Powers (2003a, 2003b) estimate that at-issue yields of bonds with make-whole call provisions average 11 bp more than yields of comparable non-callable bonds.3 The lack of a model, however, prevents them from assessing whether this is fair compensation. Our second objective is to understand how characteristics of the bond such as time-to-maturity, of the issuing ﬁrm such as leverage, and of the yield curve such as its level should aﬀect the incremental yield. Again, without a model, insights thus far have been limited to simple intuition. To accomplish these objectives we ﬁrst develop a structural credit spread model. In our model, risk-free rates and ﬁrm cash ﬂows are given by correlated stochastic processes while default and call decisions are endogenous. Credit spreads for both make-whole call and non-callable bonds are then calculated numerically. As noted, our primary interest is in the

In our sample, make-whole premiums range between 0 bp and 100 bp with a mean (median) value of 25.6 bp (25 bp); 99.3 percent are less than 50 bp. In comparison, the 10-year Aaa industrials credit spread has ranged from a low of 32 bp in February, 1997 to a high of 130 bp in May, 2000. 3 In both papers, they measure the cost of the make-whole call provision by subtracting maturity and rating-speciﬁc Bloomberg Fair Market Yields from observed at-issue yields for matched samples of makewhole call and non-callable bonds. The resulting yield diﬀerential for make-whole call bonds bonds is 11 bp more than the diﬀerential for comparable non-callable bonds. In comparison, the yield diﬀerential for ﬁxed-price callable bonds is 45 bp greater than the equivalent non-callable value.

2

2

incremental yield attributable to a make-whole call provision and not in credit spreads per se. Thus, for make-whole call bonds, we disentangle the default and call option components of the credit spread by subtracting the predicted spread of an otherwise equivalent non-callable bond. The incremental yield resulting from this calculation is the cost of the call option. We parameterize our model using contemporaneous risk-free yield curve information as well as ﬁrm and bond-speciﬁc characteristics at origination for a sample of approximately 1,300 recently issued make-whole call and non-callable bonds. For each bond in the sample, we calculate what its credit spread should be assuming that capital markets are frictionless and that calls only occur when economically optimal. For make-whole call bonds, the predicted incremental yield has a sample mean (median) of 2.75 bp (1.75 bp). Regression analysis reveals that our model-generated values successfully capture cross-sectional variation in observed incremental yields. However, after controlling for a variety of other factors such as liquidity and the macro-economic credit environment, we ﬁnd that observed values average more than 11 bp and that the diﬀerence between model-generated and observed values is statistically signiﬁcant. Thus, our frictionless model signiﬁcantly underestimates observed incremental yields. Recent research by Elton, et al. (2001) highlights the impact of imperfections such as state taxes on corporate credit spreads. Similarly, we hypothesize that the disparity between predicted and actual incremental yields can be explained by market imperfections that are likely to increase the incremental yield. Thus, we extend the model by parameterizing and incorporating three real-world market imperfections. The ﬁrst imperfection is capital gains taxes assessed on the diﬀerence between the call price and basis price of taxable investors if the bond is called. The second imperfection is transactions costs that are imposed on debtholders when they are forced to rebalance their investment portfolios following a call. The third imperfection is an exogenous event which requires the ﬁrm to retire debt for a 3

In this situation. In section 2 we develop the model. For example.potential misspeciﬁcation is likely to be minimized. the model-generated mean (median) incremental yield increases to 6. and discuss comparative statics 4 . early retirement of the acquired debt may be desirable. we conclude that make-whole call provisions have been overpriced at origination and issuing ﬁrms have paid too much for the ﬁnancial ﬂexibility provided by this innovative call option. and Huang. regression results still indicate that model-generated values are statistically signiﬁcantly less than empirically observed values. however. may help the ﬁrm avoid and even costlier tender oﬀer. The data is described in section 3. Extensive robustness checks. Moreover. Helwege. After incorporating all three imperfections. This increases the model-generated incremental yield by pushing the call provision closer to being in-the-money. One reason to believe this is because our structural model underestimates credit spreads in general. We have also focused only on imperfections likely to increase the incremental yield and have ignored others that might have the opposite eﬀect. we believe that our model-generated values may actually overestimate what should be the cost of a make-whole call provision.44 bp).calculated as the diﬀerence between make-whole call and equivalent non-callable bond yields .reason other than the call being suﬃciently in-the-money. A make-whole call provision. In section 4 we use the data to calibrate the model for individual bonds. Thus. even though it is out-of-the-money relative to the market price of the bond. debt assumed in an acquisition or merger might contain covenants that restrict the ability of the ﬁrm to conduct business. suggest that this is not the case. Our results could potentially be due to misspeciﬁcation of the model. bringing results closer to empirically observed values.07 bp (5. Nevertheless. The rest of our paper proceeds as follows. calculate model-generated credit spreads. a sympton common to many structural models (Eom. Since we concentrate on incremental yields . 2002).

The residual cash ﬂow net of debt payments and production costs is paid to the equityholders as a dividend. See their paper for a detailed discussion of the antecedent modeling literature. the call price is calculated as the maximum of par value or the present value of the remaining scheduled debt payments. At each instant. The discount rate for the present value calculation is the prevailing risk-free rate plus the make-whole-call premium. The debt is a coupon bond with principal due at maturity and is either non-callable or has a make-whole call provision. In section 6 we extend the model and discuss alternative sources of the incremental yield. Default occurs when Acharya and Carpenter (2002) use a similar setting for analyzing ﬁxed-price call provisions with the principal diﬀerence being that we assume cash ﬂows are stochastic while they assume ﬁrm value is stochastic. followed by a conclusion in section 8. or to default. in which case debtholders recover the ﬁrm’s value and equityholders get nothing. the ﬁrm decides to make the coupon payment and pay production costs. the ﬁrm must decide whether to call the bond or leave it in place. If called. Sales and the risk-free rate are assumed to be correlated stochastic processes with a constant correlation coeﬃcient. the ﬁrm can costlessly issue equity. The ﬁrm is assumed to make optimal default and call decisions. For a callable bond.1 Model Time Line At time zero the ﬁrm borrows an exogenous amount. 2 2. the ﬁrm generates cash ﬂow by producing sales at a ﬁxed cost. if default does not occur. If cash ﬂow is insuﬃcient to cover debt payments. The model-generated credit spreads from section 4 are compared to realworld at-issue credit spreads of both make-whole call and non-callable bonds in section 5. Robustness checks of both the model and the empirics are provided in section 7.4 At each instant. 4 5 .of the model.

(1) where κr is the mean-reversion rate. All production costs p (p ≥ 0) are assumed to be ﬁxed through time. Both equity and debt are priced fairly taking into account the optimal call and default strategies of the ﬁrm. hereafter) model: √ drt = κr (r∗ − rt )dt + σ r rt dWr . the cash ﬂow available to pay debt and dividends is s − p. 6 . and σ s is the instantaneous volatility coeﬃcient.sales decline and the market value of the ﬁrm’s equity becomes zero.2 The ﬁrm’s cash ﬂow and production costs We assume that the ﬁrm continuously generates sales s through time. described by the one factor Cox. 2. 2. s (2) where α is the convenience yield. Sales for the ﬁrm are assumed to follow a log-normal stochastic process: ds = (r − α)dt + σ s dWs . a call occurs when sales increase and the ﬁrm is able to issue an equivalent bond with a yield that is less than the risk-free rate plus the make-whole call premium of the existing bond. The Wiener processes Wr and Ws are correlated with correlation coeﬃcient equal to ρ.2 2. and Wr is a standard Wiener process under the risk-neutral measure. Thus. σ r is the instantaneous volatility for the short-term rate. regardless of the level of sales.2. Ws is a Weiner process under the risk-neutral measure. Ingersoll and Ross (1985) (CIR.1 Model Description The interest rate process The short-term risk-free rate rt is assumed to follow a mean-reverting square root stochastic diﬀusion process. r∗ is the long-term level to which the short-term rate reverts.2. In contrast.

s − p − c. For a bond that has T − t remaining until maturity. Brennan and Schwartz. t).2.Fixed production costs imply that even an unlevered ﬁrm can become ﬁnancially distressed. 7 . c. (1984). F. The sales level at which ﬁnancial distress induces the unlevered ﬁrm to shut down is endogenously determined such that the value of the ﬁrm is always greater than zero. x) is the price of a risk-free zero coupon bond paying $1 at time x.3 Bond types We assume that the ﬁrm issues a bond that has a continuous coupon payment rate of c per unit of time and par value F at maturity T. t. t. t < T at which the ﬁrm can call its debt is calculated as the present value of the remaining coupon payments c and par value F discounted at the risk-free rate plus some prespeciﬁed premium m > 0. T − t) = max{F. t. (3) where P (r. 2. The call price of a bond with a make-whole call provision is determined by the remaining maturity t and by the level of the risk-free rate r. m. c. calculated according to the CIR formula 5 This ﬁxed production costs assumption extends Merton’s (1977) classical model of the ﬁrm and enhances our ability to calibrate the model to match cash ﬂow characteristics of individual ﬁrms.5 A distressed ﬁrm can either costlessly issue equity (via a negative dividend) or can shut down operations permanently. Mello and Parsons (1992). m. We consider two types of bonds: 1) a bond with a make-whole call provision and 2) an option-free or non-callable bond. x)dx] + F · P (r. T )e−m(T −t) }. F. the call price is given by M(r. temporary shut downs are not allowed. and Mauer and Ott (2000) make similar assumptions with respect to costs. The ﬁrm continuously pays dividends that equal sales net of production costs and debt payments. There is a ﬂoor for the call price specifying that it cannot be lower than the face value of the bond F . [ Z T t ce−mx P (r. The call price M(r.

and τ is the stopping time corresponding to when sales drop to the critical lower boundary at which the unlevered ﬁrm shuts down its operations. t.P (r. r.2. the value of the unlevered ﬁrm V (s. B(x − t) = r r 2γ + (κr − γ)(1 − e−γ(x−t) ) (4) The last two terms in equation 3 are the present values of the coupon payments and of the par value discounted at the risk-free rate plus the premium m. Given the value of the short-term interest rate r and the sales level s. F. where c is the coupon rate. r. and γ = κ2 + 2σ 2 . (5) where E is the expectation under the risk-neutral measure. t) = max[E(V (s. r) = max E τ Z τ 0 (st − p)e− Rt 0 rs ds dt. the value of the ﬁrm’s equity is E(s. t).4 Value of the unlevered ﬁrm The value of the unlevered ﬁrm equals the expected present value under the risk-neutral measure of the discounted future cash ﬂows taking into account the option to shut down operations if sales are suﬃciently low. F is the face value. m. M. 2. r) − F )]. T. T − τ ))e− (s − p − c)e− τ Rx t E Z τ ry dy t dx + δ(T − τ )e− 8 RT t Rτ t ry dy . F. x) = ( 2κr r ∗ /σ2 2γe(κr −γ)(x−t)2(κr −γ) r rB(x−t) ) e . (6) ry dy max(0.5 Value of the ﬁrm’s equity and debt For a levered ﬁrm having debt with characteristics c. 2. where −γ(x−t) ) 2γ + (κr − γ)(1 − e p −2(1 − e−γ(x−t) ) . VT (s.2. . r) is given by the solution to the following problem V (s. r) − M(r. Equity’s value depends on the optimal default and call strategies and is given by E(s. c. T is the maturity of the debt and M is the call price for each t < T and risk-free rate r.

t) = V (s. (10) In the absence of taxes. (9) (7) (8) For a callable bond there is another free boundary condition that corresponds to the case where the ﬁrm buys the debt back at the make-whole call price M(r. t): D(s. m. F ). The details of equity valuation are discussed in the appendix. the debt value is given by the minimum of par value F and the value of the ﬁrm’s assets V : D(s. There is a boundary condition for the value of debt when equity is valueless and the ﬁrm defaults:6 D(s. r) − M(r. T ) = min(V (s. F. t) = V (s. t). In the equation the subscripts denote partial derivatives. Note that the sales level at which the levered ﬁrm will default is greater than the sales level at which the unlevered ﬁrm shuts down its operations. the equity value E. t) if E(s. m.where the stopping time τ either corresponds to the time of default. if E(s. satisfy V = E + D. or maturity. The function δ in (6) is given by δ(x) = 0 if x 6= 0 and δ(0) = 1. F. r. c. 6 (11) This boundary condition assumes that assets of the levered ﬁrm are transferred to bondholders following default. 2.6 Valuation of the Debt To calculate the value of the debt D. c. r. we need to consider the ﬁrm’s default and call strategy (if applicable). the value of the ﬁrm V . the value of debt satisﬁes √ σ2r σ 2 s2 r Drr + s Dss + ρσ s σ r s rDrs + κr (r∗ − r)Dr + (r − α)Ds + 2 2 + Dt − rD + c = 0. c. bond call. F. t) = 0. t) = M(r. r. r). r. m. Prior to maturity. At maturity T. r).2. and the value of the debt D. r. 9 . ﬁnancial distress costs and bankruptcy costs.

(6) not asset backed.511 non-callable bonds. (7) not putable.870 bonds with make-whole call provisions. we match each observation to the corresponding prior ﬁscal year record in Compustat.262 non-callable bonds and 1.662 non-callable bonds and 1. (3) denominated in US dollars.583 make-whole call bonds for which we have at least sales data for the issuing ﬁrm. We also eliminate make-whole call bonds for which we are unable to determine the make-whole premium via either Bloomberg or by direct inspection of the bond prospectus. (9) not a Yankee bond. all characteristics are winsorized at the 1st and 99th percentiles for 10 . With the exception of sales. per bond type in each issue year. (2) maturity of at least one year. (4) oﬀering amount of at least $25 million. we allow only one observation per ﬁrm. Panel A. 2. (11) not part of a unit oﬀering. The selected bonds have the following characteristics: (1) issued on or after January 1. (8) without a sinking fund. (10) not a Medium Term Note. we present means and medians for characteristics of the ﬁrms responsible for issuing the 1. 1995.3 Data We calibrate and test our model using a sample of bonds drawn from the Fixed Income Securities Database (FISD). These requirements reduce our sample to 2. Using the 6-digit Cusip of the issuer provided in the FISD. We exclude bonds with ﬁxed-price call provisions and those for which there is no information in the FISD on the at-issue yield-to-maturity. In columns one and two of Table 1. In calculating these statistics. and 2. Observations are lost either because the ﬁrm is not listed in Compustat or because the bond was issued by a subsidiary of a ﬁrm rather than the actual parent ﬁrm. the source for the issuer-speciﬁc information required for our pricing model. (12) not convertible. (5) ﬁxed semi-annual coupon.447 bonds with make-whole call provisions. These screens result in an initial sample of 2.800 bonds with ﬁxed-price call provisions. and (13) listed as a Corporate Debenture.

however. The summary statistics indicate that the typical make-whole call bond has a worse rating. Make-whole call issuers also have greater book leverage. As can be seen from the summary statistics. and moderately larger oﬀering amount than the typical non-callable bond. some univariate diﬀerences are potentially due to diﬀerent economic conditions prevailing at the issue date. or extremely high or low input parameters.the entire Compustat universe in order to limit extreme outliers. the typical issuer of a make-whole call bond is smaller. Finally. Our ﬁnal sample. we report all of the same summary statistics in columns four and ﬁve. Our initial sample includes 1. All of the prior comparisons that were signiﬁcant remain statistically signiﬁcant (p-values not reported in the table). Thus.662 non-callable bonds and 1. is limited to 775 non-callable bonds and 612 make-whole call bonds. 10 years 11 . longer maturity. Observations are lost/discarded when we parameterize our model for reasons such as no equity price available which makes calculating a proxy for Tobin’s Q impossible. more proﬁtable. Note that make-whole call bonds are more prevalent in the later half of our sample period. but there is no signiﬁcant diﬀerence in the respective medians. Average historical sales growth and volatility of sales growth are signiﬁcantly greater for the make-whole issuers (both variables are highly skewed). Column three contains p-values for t-tests and Wilcoxon Rank-Sum tests (in parentheses) of the null hypothesis that means and medians for the associated variables are the same for the two samples. Panel B shows means and medians for characteristics of the actual bonds in the sample (no bonds are excluded). the volatility of the ﬁrm’s daily excess equity return for the prior six months is signiﬁcantly greater for make-whole call issuers. insuﬃcient information for calculating the standard deviation of sales growth. For the issuers of bonds that make it into our ﬁnal sample.583 make-whole call bonds. The median make-whole call bond has a rating of BBB. and appears to have greater growth opportunities (as proxied by Tobin’s Q) than the typical non-callable bond issuer.

Our model-generated credit spread. 9 years to maturity. 2. ρ.7 The mean and median credit spreads for the non-callable bonds are 117 basis points and 88 basis points. Consistent with their lower ratings. For the ﬁrm. and 30 year yields implied by the closed-form solution of the CIR model and the real-world Constant Maturity Treasury (CMT) yields for the same maturities. minimizing potential bias. respectively. and an oﬀering amount of $250 million. T. To estimate the parameters of the risk-free process. the long-term rate r∗ . m. and the capital structure of the ﬁrm (F. will be reported on the same basis. however. Comparisons are similar for the ﬁnal sample bonds reported in columns 4 and 5. r∗ . σ r ). the mean and median credit spreads for the make-whole call bonds are statistically signiﬁcantly greater at 179 basis points and 155 basis points. 10. the sales process of the ﬁrm (σ s . respectively. 3. the median non-callable bond has a rating of A-. 4 4. In contrast. the correlation between the Duration bias is a potential concern since we are making a comparison to the equivalent maturity (not duration) CMT yield. In situations where an equivalent maturity CMT yield is unavailable. we interpolate linearly using the two closest maturity CMT yields. we calculate the credit spread as the bond’s yield-to-maturity at issue minus the equivalent maturity Constant Maturity Treasury (CMT) yield. This is done independently for each bond origination date. and an oﬀering amount of $300 million.1 Model Output Calibration To use the model. Helwege. 5. and Huang (2002). and the volatility σ r which minimize the sum of squared deviations between the 1.to maturity. p. κr . we solve for the short-term rate r. c). the mean reversion rate κr . longer maturities. we require parameter values for the risk-free interest rate process (r. 7 12 . Following Eom. we approximate the volatility of the sales process σ s using the standard deviation of annual sales growth for the prior 10 years. α). For ρ. and prevalence later in the sample period when credit spreads are wider.

Wiener processes driving the risk-free rate and sales. hold all other values constant at sample averages. we calculate the median correlation between sales growth and changes in the short-term risk-free rate over the prior 10 years for the ﬁrm’s industry. 10. the most important being issuing ﬁrm leverage and bond maturity. The estimated coeﬃcients from this regression are then used to calculate average credit spread values for our twelve representative bonds. the growth rate is large (small). To set α. regression analysis (results not presented in tables) indicates that Q and observed credit spreads are signiﬁcantly negatively related.average observed spread) / average observed spread)2 is minimized for To calculate average observed credit spreads.g. we solve for a and b such that the sum of squared relative prediction errors ((modelgenerated spread . Instead. 1998). Shin and Stultz.8 We then assume that the mapping between Q and α for these representative bonds has the following functional form: α = a + b ∗ ln (Q) . however. 8 13 . To approximate production costs for the ﬁrm p. Characteristics of these representative bonds correspond to typical 5. A similar process is used to calculate average Q for the representative bonds. we need an estimate of growth expectations for the ﬁrm. ( TT otalMarket V alue ) to measure Book V alue growth opportunities. we use a proxy for Tobin’s Q. The primary eﬀect of α. we ﬁrst regress actual at-issue credit spreads for our entire sample of non-callable bonds on a variety of observed characteristics. Baa. To map Q into α. when α is small (large). we set leverage equal to the average leverage value for medium term non-callable Baa bonds in our sample. we ﬁrst calculate average observed credit spreads and Q for twelve representative non-callable bonds. it is a noisy measure otal in real-world data. Furthermore. This proxy for growth is common in the corporate ﬁnance literature (see e. and then calculate a predicted value. or Ba. Sales Technically. the parameter α is the payout rate (or convenience yield) of the ﬁrm. we calculate the ﬁrm’s 5 year average of ( Sales−EBIT ). and 30 year bonds in our sample with ratings of either Aa. (12) Finally. A. is that it adjusts the risk-neutral growth rate of ﬁrm sales. While the ratio of EBIT T otal Market V alue is a theoretically appealing measure of growth in the context of the model. therefore. For a medium term Baa bond for example. set maturity equal to 10 years.

Helwege. if the bond has a make-whole call provision then m is set equal to the make-whole premium given in the bond’s indenture. Ogden (1987). T otal Market V alue While we could set F to match observed market leverage. Mason. book leverage ( T otal Assets ) is more highly correlated with at-issue credit spread (ρ =0. This is a necessary ﬁrst step if we want to value the credit spread option given by the make-whole call provision. We do. including the make-whole call bonds. and Rosenfeld (1984). the observed value tends to be noisy and aﬀected by exogenous market-wide variation in equity prices. Thus. 2002). Thus. Mason. Debt .0501 and b = −0.34) Debt than is market leverage ( T otal Market V alue ) (ρ =0. Empirical studies that analyze the eﬀectiveness of structural models such as Jones. leverage in the model corresponds to market leverage. 9 14 . Note that in the model there are no physical assets per se and thus no book value of assets. we are implicitly assuming that the bond’s maturity is representative of all debt in the ﬁrm’s capital structure. 2000 or Huang and Huang. c is also the yield-to-maturity of the bond. These values are then used in mapping Q into α for all sample bonds. Debt 10 In our data. and Eom. Debt . To get the coupon rate c.9 For the capital structure of the ﬁrm. We therefore set F to match observed book leverage. it is a parsimonious method of getting our model to approximate real-world credit spreads.11 Similarly. however. we ﬁrst establish the degree of ﬁnancial leverage by setting the face value of debt F . calculate the value of the ﬁrm. and Rosenfeld (1984) note that contingent claims models are diﬃcult to implement when pricing individual bonds since the models must assume simple capital structures while real-world capital structures are often quite complex. and Huang (2003) ﬁnesse this issue by focusing on ﬁrms with very simple capital structures. The resulting values are a = 0. While our transformation of Q into α may seem ad-hoc.27).the representative bonds. we numerically solve for the value such that the bond is priced at par.10 T otal Assets Debt maturity T is taken directly from the bond that we are analyzing.0136. Other papers use similar methods to set appropriate parameters (see Anderson and Sundaresan. 11 Jones.

For non-callable bonds. it is due to systematic diﬀerences in other characteristics as illustrated in Table 1. While our model underpredicts credit spreads on average. and reported in their Table 3. For make-whole bonds. we parameterize the stochastic processes to match observed characteristics of the risk-free yield curve. ﬁrm. 14 The models tested by Eom et al. We calculate a weighted-average maturity of the ﬁrm’s debt listed in the FISD.6) years. and Huang (2003).4. are an extended version of Merton (1974). while our simplifying assumption will induce noise in our estimates.14 This is particularly notable As will be seen later. Helwege. and Eom. we provide summary statistics on prediction error calculated as predicted spread minus observed spread. 12 15 . Rather. and Collin-Dufresne and Goldstein (2001). and bond at the origination date. the mean (median) predicted spread is 81 (38) basis points. its predictive ability is on par with the structural models tested by Jones.2 Model-Generated Spreads For each bond in the ﬁnal sample. Lyden and Saranti (2000). Their best performing models are Merton (1974) and Geske (1977). For make-whole call bonds the prediction error is -35 (-48) bp with a standard deviation of 127 bp. the absolute percentage prediction error is of similar magnitude to the two best performing models tested by Eom et al. excluding bank debt and commercial paper. The predicted spread for the make-whole call bonds is signiﬁcantly higher at 145 (114) basis points. the predicted spread includes the incremental yield associated with that bond’s make-whole call provision. Therefore. calculated as prediction error divided by observed spread. 13 A potential concern is our assumption that maturity of the individual bond is representative of all of the ﬁrm’s debt. Leland and Toft (1996). For non-callable bonds the mean (median) value of the prediction error is -26 (-44) bp with a standard deviation of 98 bp. For example. Wei and Guo (1997).13 To assess the general ﬁt of our model. and Rosenfeld (1984). and subtract it from the maturity of the individual bond. Table 2 displays the predicted credit spread relative to the model-generated comparable maturity risk-free yield. Geske (1977).2 (0. The diﬀerential is approximately the same for both types of bonds and has a mean (median) value of 1. it should not induce bias. We also report percentage prediction errors.12. Longstaﬀ and Schwartz (1995). Mason. most of the diﬀerence in predicted spreads between the non-callable and the makewhole call bonds is not due to the make-whole call provision.

Eom. Regression analysis of the prediction errors (results not presented in tables) shows that they are positively related to most of the ﬁrm and bond-speciﬁc model inputs such as leverage. the total spread can be thought of as compensation demanded by bondholders for the two options owned by the issuer: (1) the option to default and (2) the option to call. the ﬁrm will call only when it can proﬁtably refund the existing bond with an equivalent bond at lower cost. For this to occur.1 basis points and a minimum of 0 basis points. samples where structural models are expected to work best.e. i. After diﬀerencing.given that all of the previously mentioned empirical studies limit their samples to bonds issued by ﬁrms with simple capital structures.. the likelihood of such a refunding opportunity is small. costs/sales. Anderson and Sundaresan (2000) and Huang and Huang (2002) all show that this is a common characteristic of structural models. the comparatively small incremental yield reﬂects two facts. Taking the diﬀerence in this manner should substantially reduce any unobserved bias possibly introduced by the model. the payout ratio α. In a perfect capital market. volatility of sales. and Huang (2003). Intuitively. Helwege. however. the small incremental yield reﬂects that the payoﬀ to the ﬁrm from exercising the call is 16 . Given the small magnitude of makewhole premiums. we calculate the sample mean (median) modelgenerated incremental yield to be 2. The result is that we tend to underestimate credit spreads for short-term and highly rated bonds and overestimate credit spreads for long-term and poorly rated bonds. To estimate the incremental cost of the option to call. we subtract the predicted spread for an equivalent non-callable bond from the predicted spread for the make-whole call bond. the credit spread on new borrowing for the ﬁrm must be less than the make-whole premium and the market price of the bond must be above par (or else the call price ﬂoor at par is binding).75 (1. and maturity. First.75) basis points with a maximum of 22. Second.

lower production costs. the predicted credit spread for the equivalent non-callable bond is 65. κr =0. and m=24 bp. r∗ =6. values are σ s =11. The incremental yield is larger while the noncallable credit spread is smaller for ﬁrms that have lower volatility of sales. For a bond with ﬁve years until maturity and a 7 percent coupon. holding all other parameters constant.89 bp. lower leverage.027. To provide meaningful comparative statics. The second order eﬀect. and σ r =10% annualized.75 percent rather than at 7 percent implies a savings of $10.46 per $1. discounting at 6. we examine how changes in underlying parameter values aﬀect the incremental yield attributable to a make-whole call provision. for capital structure.3 Comparative Statics In this section. Next.capped.4%.56%. The parameter values for the base case correspond to a typical bond in our sample and are as follows: r=4. and greater growth opportunities. however.5%.21 bp and the incremental yield attributable to the make-whole call provision is 3. is a reduction in the value of the call option since ﬁrms that are more likely to default have less incentive to exercise the call option. Given the competing nature of the default and call options. 15 17 . the non-callable credit spread increases .171 per year. ρ=0.77%. values are F V =18.000 of face value. we ﬁrst parameterize a base case for our model. Finally. these results are intuitive. The comparative statics indicate that in most cases.01%. p=78%. we vary each parameter by reducing it to approximately its 25th percentile value and then increasing it to approximately its 75th percentile value. For these parameter values. For the sales process. the incremental yield and the noncallable credit spread are inversely related. As the option to default becomes more valuable. This leads to a decline in If the make-whole premium is 25 bp. The resulting non-callable credit spreads and incremental yields are reported in Table 3. the most that the ﬁrm can save when refunding is 25 bp of yield.a ﬁrst order eﬀect. and α=4. T =10 years.15 4.

To accomplish both objectives.4% to 17. Note that for a make-whole call bond. for the make-whole premium.04 bp while the incremental yield declines from 3. 5 Empirical Analysis of Incremental Yields We have two primary objectives in our empirical analysis. For the base case bond for example. The second objective is to compare the magnitude of observed incremental yields to the model-generated incremental yields.21 bp to 170. The ﬁrst is to determine whether our model captures the cross-sectional variation in the incremental yield associated with a make-whole call provision. as the risk-free yield increases. an increase in sales volatility from 11. then this helps to validate the comparative statics discussed in section 4. the non-callable credit spread narrows and the incremental yield increases.89 bp to 5. This is not true. there is little that issuing ﬁrms can do to adjust the parameters for which we present comparative statics.4% increases the non-callable credit spread from 65. To control for the default component of credit spreads. Because of the practical importance of the relationship between the make-whole premium and the incremental yield. this is the model18 .3. A larger make-whole premium is tantamount to a lower exercise price. we include the model-generated non-callable bond credit spread as an independent variable NC CSpm . This results in a larger incremental yield. however. The inverse relationship between incremental yield and non-callable credit spread also holds as the level of the yield curve varies. we plot the relationship in Figure 2. an increase in the make-whole premium from 24 bp to 30 bp leads to a substantial increase in the incremental yield from 3.the incremental yield.89 bp to less than 1 bp. For example. we rely on regression analyses where the dependent variable is the observed credit spread CSpo at origination. If so. In most cases.44 bp. issuing ﬁrm are free to choose any value that they desire.

We also include a variety of controls in the regression for bond. we estimate the following equation using Ordinary as well as Robust Least-Squares: CSpo = a0 + a1 ∗ NC CSpm + a2 ∗ MW IYm + a03 ∗ (Controls) + ε. MW IYm is set equal to zero. we include the diﬀerence between Moody’s Seasoned 10-year Baa corporate yield and the 10-year Constant Maturity Treasury (CMT) rate (Baa CMT Sp). There was also a signiﬁcant increase in idiosyncratic equity volatility (Campbell and Taksler. we During the sample period.) Since actual rating is correlated with our model-generated credit spread. it is not incorporated in our model and must be controlled for separately. 2003). While this additional risk is reﬂected in real-world credit spreads. we include the model-generated incremental yield for make-whole call bonds MW IYm . 5. For non-callable bonds.16 Elton et al. Helwege. etc. Throughout the sample period. (13) If our model is a perfect representation of reality and our parameterization process is without error. Aa = 3. ﬁrm. As our primary analysis. and economy-wide factors which have been shown to aﬀect credit spreads but which are not incorporated in our structural model.generated credit spread for an equivalent non-callable bond. Aa+ = 2. and Huang (2003). there was a “ﬂight to quality” during the Asian debt crisis of 1997 and the Long-Term Capital Management and Russian debt crises of 1998. (2001) show that low credit quality bonds expose investors to systematic risk in addition to default risk. 16 19 . we use an ordinalized rating variable (Aaa = 1. then we expect estimated coeﬃcients of 0 for a0 and 1 for a1 and a2 . there is wide variation in the seasoned credit spread ranging from 124 to 383 basis points. To capture the incremental yield associated with a make-whole call provision. Following Eom.1 Exogenous Control Variables To account for exogenous variation in the credit environment due to macroeconomic ﬂuctuations.

ﬁrst orthogonalize the ordinal rating variable before including it in our primary regression. and Livingston and Zhou (2002) ﬁnd that credit spreads for bonds issued privately under Rule 144a are signiﬁcantly greater than for comparable publicly issued bonds. Chaplinsky and Ramchand (1997). We do this by estimating an ordered logit regression with ordinal rating as our dependent variable and NC CSpm as the independent variable. Since idiosyncratic volatility is positively correlated with MW IYm .5 percent of our sample where Discussions with representatives of the two major bond rating agencies (Moody’s and Standard and Poors) indicate that the existence of a make-whole call provision does not impact the rating assigned to a bond.18 Nevertheless. Campbell and Taksler (2003) ﬁnd that the relationship between observed credit spreads and the volatility of daily excess stock returns is signiﬁcantly stronger than what is found when simulating the Merton (1974) model. The latter two papers also ﬁnd that credit spreads are greater for ﬁrst-time bond issuers (see also Datta. 17 20 . We expect that much of the extra explanatory power of idiosyncratic equity volatility will already be controlled for via our inclusion of Residual Rating and Baa CMT Sp. we report regression results both with and without the volatility measure. Our model already incorporates a measure of ﬁrm volatility. for bonds classiﬁed as senior.17 The residual from this regression Residual Rating is then included in our analysis of CSpo and functions as a proxy for all of the characteristics of the bond and ﬁrm that we are unable to observe. we do not include M W IYm when we orthogonalize. To control for private versus public. 18 In addition to ﬁnding a cross-sectional relationship. First Bond is coded one for the 17. 1997) and. Iskandar-Datta and Patel. we include a dichotomous variable Rule 144A that is coded one for the 13. Thus. however.8 percent of our bonds that are privately issued. after controlling for rating. For non-rated bonds (71 cases). we include Equity Volatility as an independent variable. Campbell and Taksler (2003) show that aggregate corporate yield spreads widen during periods of higher idiosyncratic volatility. we replace the missing value for Residual Rating with a zero and then code a dichotomous variable Not Rated to one. Fenn (2000).

19 5. R 20 The robust regression procedure available in Stata 7. Senior is coded one for 94. Bonds issued by utility ﬁrms comprise 6. Elton et al. The ﬁrst column presents OLS estimates.8 percent of our sample. Finally.0 ° is an iterative weighted least squares process where the weights are inversely proportional to residuals from a previous pass. though. medium-term and long-term bonds. Chen. Subsequent results are robust to including dichotomous variables distinguishing short-term. and Duﬀee. 1991. 1999). 19 21 .2 Regression Results Results from estimating equation (13) for the entire sample are displayed in Table 4. however. as controls for liquidity. We include Log Oﬀering Amount and Log Maturity.9 percent of our bonds that are designated as either senior or senior-secured. Including the log of maturity is also motivated by research indicating that the observed term structure of credit spreads widens with maturity (Litterman and Iben. Fons. Therefore. and Wei (2002) show that bond liquidity is negatively related to credit spreads. Their measure of liquidity is beyond the scope of this paper. It is unclear. they ﬁnd that their liquidity measure is negatively related to maturity and positively related to amount outstanding.20 Inclusion of Equity Volatility distinguishes the speciﬁcation in the third Our model generates an upward-sloped credit spread term structure. we also include a dichotomous variable Utility for utility issuers.3 percent of our bonds that are issued by ﬁnancial service ﬁrms and zero otherwise. Lesmond. Since utility ﬁrms are often regarded as distinctly diﬀerent credit risks. 1994. The second and third columns present robust least squares estimates. (2001). This reduces the inﬂuence of outliers. Thus. therefore. it is prudent to include log of maturity as an exogenous control. whether the observed slope is entirely due to the default risk captured by our model. we include a dichotomous variable Finance that is coded one for the 21. and Campbell and Taksler (2003) document that yield spreads for bonds issued by ﬁnancial service ﬁrms are between 10 and 20 basis points greater than yield spreads for industrial bonds.no earlier bond issued by the same ﬁrm is recorded in the FISD.

22. Credit spreads are greater for: longer maturity bonds. the oﬀering amount is large. In each speciﬁcation. analysis of the regression residuals shows that the variance of the residuals increases noticeably with the predicted credit spreads. Similarly.21 The diﬃculty with outliers can be almost totally eliminated by replacing CSpo .column from the speciﬁcation in the second column. our proxy for unobserved characteristics outside the scope of our structural model. The estimated coeﬃcient for NC CSpm is 0. The estimated coeﬃcients for Residual Rating. bonds that represent the ﬁrst debt issue of the ﬁrm.22 InterThis is consistent with Elton et al. and for bonds issued by ﬁrms with volatile equity prices. At-issue credit spreads increase with Moody’s seasoned bond credit spread. and when the bond has seniority. and Baa CMT Sp with their respective logs and MW IYm with log(1 + MW IYm ). Credit spreads are lower when the yield curve is steeply sloped. While the estimated coeﬃcient is substantially less than one . The estimated coeﬃcient for MW IYm is 6. The impact of issuer industry (Finance and Utility) depends on the speciﬁcation. NC CSpm . (2001) who note that greater bond default risk leads to greater credit spreads and to greater uncertainty as to the appropriate value of the bond. Mansi.07.219 with a highly signiﬁcant t-statistic of 6. privately issued bonds. Nejadmalayeri (2002) and Joutz. In the OLS results of the ﬁrst speciﬁcation.257 with a heteroscedasticity-consistent t-statistic of 12. Indeed.the statistical signiﬁcance suggests that our structural model does capture a signiﬁcant amount of real-world variation in credit spreads. and Maxwell (2002) show that variation in credit spreads increases as bond rating deteriorates.the value that would be expected if our model and its parameterization were a perfect representation of reality . 22 Taking the log of M W IYm without ﬁrst adding one is problematic since M W IYm is equal to zero for 21 22 . We caution that these results are sensitive to outliers in the data. the signs of estimated coeﬃcients for the exogenous control variables are generally as expected and values are statistically signiﬁcant. The more important results are those that pertain to the model estimates. are positive and highly signiﬁcant.

then we expect an estimated coeﬃcient of one for MW IYm . Instead. Empirical results from the robust OLS regressions suggest incremental yields of 4.257 to 0.866×2. the baseline model predicts an incremental yield of 2. By pure economic value we mean the gains that the ﬁrm can seize when credit spreads narrow to the point that the make-whole call provision is in-the-money. there are alternative sources of incremental yield that are not captured in the over half of the observations. Including idiosyncratic equity volatility as is done in speciﬁcation 3 has minimal eﬀect on the estimated coeﬃcients for the model-generated values. Given our results.preting coeﬃcient in this regression.0000 for both speciﬁcations two and three.359×2. but the t-statistic increases to more than 18. 6 Potential Sources of Additional Incremental Yield The incremental yield generated by our model reﬂects the pure economic value of the makewhole call provision.359 with a t-statistic of 8.219 to 4.63 bp for speciﬁcation three. is not straightforward (results available from authors. how do we interpret the estimated coeﬃcients for MW IYm ? If the real world pricing of make-whole call provisions perfectly coincides with our model’s predictions. we report robust OLS results in the second and third regression speciﬁcations. 23 .46. the estimated coeﬃcient for NC CSpm declines from 0.75 bp = 11. Including a dichotomous variable identifying make-whole call bonds in addition to MW IYm (results not presented in tables) does not alter results signiﬁcantly either. estimated coeﬃcients are signiﬁcantly greater than one for MW IYm .75 bp = 10. In practice. In the second speciﬁcation. the p-value of an F-test for MW IYm = 1 is . The estimated coeﬃcient for the incremental yield MW IYm also declines from 6.75 basis points.99 bp for speciﬁcation two and 3.) Instead. however. For the average make-whole call bond in our sample.184. Both values are signiﬁcantly greater than what is predicted by the model.

we discuss and incorporate three market imperfections that we believe might account for the disparity between model-generated and observed incremental yields. Other market imperfections such as transactions costs imposed on the ﬁrm when a call is exercised might reduce the model-generated incremental yields.1 Capital Gains Taxes If a make-whole call is exercised. the incremental yield for the base case make-whole call bond increases by almost 2 bp from 3. Alternatively.model. a taxable investor will owe capital gains taxes whenever the call price is greater than the investor’s basis value.70) percent of par.2 Transactions Costs A signiﬁcant percentage of corporate bonds are held by institutional investors who often have well-deﬁned investment strategies. These imperfections are capital gains taxes. If we assume that the marginal investor is taxed. and exogenous events requiring the ﬁrm to retire debt early. Since the call price has a ﬂoor at par. We choose. the institution might follow an active strategy designed to capitalize on risk-arbitrage op- 24 . Moreover. 6.83 bp. however. For example. however.59 (99. transactions costs imposed on investors when calls are executed. For every make-whole call bond in our sample. Incorporating capital gains taxes of 20 percent into our model has no impact on the non-callable credit spread. In the following subsections. taxable investors who purchased the bond when issued will invariably owe capital gains taxes if the bond is called. we try to be conservative in parameterizing the imperfections so that we do not underestimate the eﬀect that imperfections have on incremental yields. to focus only on those that we think will increase model-generated values. 6.89 bp to 5. the institution might follow a passive strategy designed to match the risk proﬁle and return of a benchmark portfolio. its oﬀering price is at par or below — the mean (median) is 99.

we assume that transactions costs are $1. m. 10) the bond value is the following: D(s. (14) Schultz (2001) presents evidence that round-trip transactions costs for investment grade bonds average $2. bondholders must pay transaction costs proportional to the face value of the bond. t). but the incremental yield attributable to the make-whole call provision increases by 0. for the one-way trip bondholders experience when reinvesting proceeds from a called bond. In model terms. This has minimal impact on the incremental yield of a make-whole call provision in a world devoid of imperfections. We do this because model-generated credit spreads decline to zero for all but the riskiest bonds as the maturity date approaches.portunities. This is a common outcome for structural models.35 per $1. Bondholders subject to the call of a bond are presumably faced with one-way transactions costs when they reinvest call proceeds since cash proceeds from the call are likely to be directly deposited into one of the investor’s bank accounts.000 of par value. However.70 per $1.20 bp. Thus. assuming that if the ﬁrm calls its debt.83 bp to 6. then the likelihood of a call approaches one as long as the make-whole premium is greater than zero.37 bp from 5. We adjust the model by incorporating this “inconvenience”. exercise of a make-whole call provision can upset the investment strategy and force the institution to rebalance the portfolio at an inopportune time.3 Make-Whole Call Provisions as a Substitute for Tender Oﬀers Survey results from Graham and Harvey (2001) make it clear that ﬁrms value ﬁnancial ﬂexibility. If the bond has a make-whole call provision.000 of par value. c.23 When transactions costs of this magnitude are incorporated in our model in addition to capital gains taxes. 6. r. when we include transactions costs. t) = (1 − T ransaction Costs) × M(r. the non-callable credit spread again stays constant. While their results imply that ﬁrms keep leverage low in order to be able to We impose an artiﬁcial restriction that no calls can occur within three months of the bond’s maturity date. 23 25 . F. the result is that these costs are imposed far too frequently unless something like the three month barrier is applied. In either case. at the call boundary (eq.

the greater the likelihood of situations requiring early redemption. To estimate the likelihood of such an exogenous event. We conservatively assume that all tender oﬀers occur at a spread of 10 bp above Treasuries. we search the transactions data in the FISD for sales of bonds where the name of the purchaser includes the word “tender”. the median tendering ﬁrm pays bondholders a premium above market value of approximately $40 per $1. any make-whole call provision with a premium of 10 bp or more will reduce the ex-post wealth transferred to debtholders. they document that CFO’s value make-whole call provisions because the call provision gives the ﬁrm ”the ability to retire 100 percent of a debt issue” without having to resort to a potentially costlier tender oﬀer. Mann and Powers (2003c) ﬁnd that tender oﬀers are primarily driven by exogenous events. This cap on the price of a successful tender oﬀer pays oﬀ in situations where a tender oﬀer would have otherwise occurred.24 For all non-callable bonds and make-whole call bonds that mature after January 1. The yield corresponding to this average tender price is approximately 50 bp above the equivalent maturity risk-free Treasury yield. resulting in a corresponding increase in the ex-ante incremental yield.issue debt in the future. They document that in the typical successful tender oﬀer. the greater should be the increase in incremental yield. Obviously. Thus. For example. but the ﬁeld is dormant and unused.000 of face value. Speciﬁcally. we are able to identify 244 tender oﬀers. debt issues acquired during a merger or acquisition may contain restrictive covenants that the surviving ﬁrm ﬁnds inconvenient and desires to eliminate. 1995 and which pass the screening criteria described in the data section. survey results from Mann and Powers (2003b) indicate that ﬁrms also value the ﬂexibility to retire debt early. This number is likely to be an under-estimate of the true number of tender oﬀers due The FISD has a ﬁeld denoting whether a tender or exchange oﬀer has ever been made for each bond. 24 26 .

60 bp. we estimate that redemptions occur in approximately 0.. Our sample identiﬁes 73. Note that we still assume that the ﬁrm with a make-whole call bond can also call its bond endogenously. To estimate the degree of underestimation. The total number of bond-years from which redemptions are identiﬁed is 41.83 bp due to the potential windfall that a tender oﬀer will generate.0083). The median number of bond years per bond is 5.e.0017)5 =0. For consistency.40 bp from 6. however. On an annualized basis.631.21 bp to 64.5% of their conﬁrmed tender oﬀers. the likelihood of observing an early redemption is only 0. The probability of such an event is assumed to be constant per unit of time and independent of the remaining maturity. If such an event arrives. With an exogenous retirement requirement. Thus. therefore. we are able to identify 13 actual calls of bonds with make-whole call provisions. imposed in addition to the two prior imperfections. one-way transactions costs as well as capital gains taxes are imposed when a tender occurs. we further modify the model by incorporating a Poisson arrival process for an exogenous event that induces the ﬁrm to retire the bond early. i. making the total number of early redemptions 345. 25 27 .83 percent of bond-years. With this information. In addition. the non-callable credit spread for the base case bond decreases slightly from 65.735 − 1) and that the true number should be approximately 332 tender oﬀers. we suspect that our sample of FISD-identiﬁed tender oﬀers 1 understates the true number by approximately 36% ( 0. for economic reasons.20 bp to 6.25 The windfall.17 percent per year (1 — (1-0. Thus. is capped in the case of the make-whole call bond.to data entry errors and a lack of data standardization. the incremental yield attributable to the make-whole call provision increases by 0. moderating the beneﬁt of the windfall. Thus. we match this sample of FISD-identiﬁed tender oﬀers to a sample of conﬁrmed tender oﬀers provided by Mann and Powers (2003c). the ﬁrm with a non-callable bond tenders for its bond at the risk-free rate plus 10 bp while the ﬁrm with a make-whole call bond can call at the make-whole call price.

noting that after incorporating imperfections. our results still suggest that the call provisions are overpriced. one might still criticize our analysis by suggesting that there are unobserved factors which explain the greater oﬀering spread for bonds with make-whole call provisions and that these factors are simply correlated 28 . F-tests indicate that estimated coeﬃcients for MW IYm are still signiﬁcantly diﬀerent from one (p-values < . Even after incorporating imperfections that likely increase the cost of make-whole call provisions. 7 7. however. model-generated credit spreads incorporate the imperfections of capital gains taxes. This is expected since the incorporated market imperfections have minimal impact on the non-callable credit spread. Regression results using the new model-generated values are reported in Table 6. Estimated coeﬃcients for the non-callable credit spread NC CSpm are also quite similar to Table 4 values. we mention only the model-generated incremental yield. Coeﬃcient estimates for this variable are noticeably smaller with values of 2.130. To save space. the incremental yield has a mean (median) value of 6.1 Robustness Checks Analysis of More Homogenous Subsamples Despite all of the control variables used in the regression analysis.44) bp.6. however. Of greater importance are the estimated coeﬃcients for the incremental yield attributable to the make-whole call provision MW IYm . In both cases. As expected. and exogenous events requiring redemption. we present the same summary statistics as given in Table 2 for sample bonds. In Table 5. We conﬁne our discussion to the robust regression results presented in the second and third speciﬁcations.4 Empirical Results Incorporating Imperfections into the Model In Table 5.07 (5. transactions costs.0001). estimated coeﬃcients for the various exogenous control variables do not change signiﬁcantly.393 and 2.

these subsample robustness checks suggest that the greater at-issue yield of bonds with make-whole call provisions is due to the make-whole call provision. One way to reduce the likelihood of unobserved heterogeneity within the issuing ﬁrms is to limit our sample to bonds with similar characteristics.or better. Estimated coeﬃcients for this matched subsample are also quite similar to the results shown in Table 6. we replicate the second speciﬁcation in Table 6 (robust OLS using modelgenerated values which incorporate imperfections) on various subsamples of the data. To summarize. 29 . In both speciﬁcations.with the presence of a make-whole call provision. results still suggest that make-whole call provisions are overpriced at origination. not to other unobserved diﬀerences between non-callable and make-whole call bonds. In the second speciﬁcation we further eliminate bonds issued by ﬁnance or utility companies since it is conceivable that these ﬁrms use call provisions in a diﬀerent manner than do industrial ﬁrms. Thus. our subsample is restricted to non-callable and makewhole call bonds issued by ﬁrms represented by at least one of each type of bond in our sample. Again results are similar to those presented in Table 6 and the estimated coeﬃcient for MW IYm is signiﬁcantly diﬀerent from one. similar maturity. and the same industry group. In the ﬁnal speciﬁcation in Table 7. results are similar to those presented in Table 6. we restrict the sample to bonds that have ratings of Baa. eliminating the low grade and unrated bonds where heteroscedasticity is greatest. In Table 7. In the ﬁrst speciﬁcation in Table 7. In the third speciﬁcation we reduce heterogeneity between the non-callable and makewhole call bonds by matching them such that for each make-whole call bond there is one non-callable bond with the same rating.

and Huang (2003).t) ) + (−α + √ d1 (x. E dVt dEt dVt (16) using the Merton (1974) Following Eom. σ E = σ V N(d1 (Kt . t)) Vt . we approximate model where. with the baseline model that does not incorporate 30 . To ensure that our results are not dependent on our most basic modeling assumption. All other characteristics of the model and the resultant solutions remain the same. rather. we use a representative group of non-callable bonds and solve for an optimal mapping of Q into α using the functional form given in equation 12. Predicted spreads and more importantly incremental yields are quite similar when compared to our original results. t) is the present value of a risk-free zero-coupon bond maturing at t.2 Alternative Models For the majority of structural models it is not sales or cash ﬂow that is stochastic. The cash ﬂows available to service debt are assumed to be a linear function of ﬁrm value.7. t) = σV t . Et σ2 V 2 (17) )t V0 ln( xD(0. (18) and where D(0. Helwege. For example. ﬁrm value V is assumed to be stochastic. we replace the stochastic process for ds/s in equation (2) with dV = (r − α)dt + σ V dWV . α is the payout rate. V (15) To parameterize the ﬁrm value variant of our model we ﬁrst calculate the annual volatility of equity σ E using the past 6 months of daily stock returns. The volatility of ﬁrm value σ V is related to σ E by σE = σV V dEt . and Kt is the amount of the ﬁrm’s debt. As before.

We then estimate regression speciﬁcation 2 from Table 6 for each subsample. Results for speciﬁcation 1 show that there is no signiﬁcant difference in the estimated coeﬃcients for the the incremental yield MW IYm . Again.3 Is Mispricing Independent of Bond Characteristics? In our ﬁnal robustness check. and rating. To do this. we investigate whether perceived mispricing is independent of basic bond characteristics. We ﬁrst split the sample based on whether the bond was issued before or after 10/1/1999. suggesting that mispricing at origination has been present across the entire time-span of the sample.002). we split the sample based on whether the rating of the bond is Baa+ or better as opposed to Baa or worse. we split the sample based on whether the time-to-maturity of the bond is more or less than 10. estimated coeﬃcients for MW IYm are not signiﬁcantly diﬀerent from one another. estimated coeﬃcients for MW IYm of 1. in speciﬁcation 3. In subsequent regression analysis (results not presented in tables) where NC CSpm and MW IYm are calculated using the stochastic ﬁrm value process.36 bp as compared to 2. This split-date is chosen because it allocates roughly the same number of make-whole call bonds to each subsample.imperfections. results are similar in magnitude and signiﬁcance to those presented in Table 4. For this sample split. (results not presented in tables).75 bp. time to maturity. The larger estimated coeﬃcient for the poorly rated bonds indicates that investors require signiﬁcantly greater compensation than predicted by our model when a make-whole call provision is attached to a poorly rated bond. the average incremental yield using ﬁrm value as the stochastic process is 2. 7. Finally. 31 .626 for highly rated bonds and 3. In speciﬁcation 2.1 years.485 for poorly rated bonds are signiﬁcantly diﬀerent from one another (p-value=0. Results are presented in Table 8. we split the sample based on issue date.

The call provision’s primary beneﬁt is that it gives the issuing ﬁrm substantial ﬁnancial ﬂexibility without the high up-front cost of a ﬁxed-price call provision. and Poulsen. Despite the prevalence of make-whole call provisions. if they become binding in the future. it is possible that the likelihood of our exogenous event should increase as credit quality deteriorates. The lower cost is directly attributable to the fact that the make-whole call price ﬂoats inversely with contemporaneous risk-free interest rates. When real-world market imperfections such as capital gains taxes. we are the ﬁrst to provide a model for valuing them. 2003) which. Poorly rated bonds are also more likely to contain restrictive covenants (Nash. This alternative. however. will provide an incentive for the ﬁrm to retire debt early.75 bp greater than a comparable non-callable bond.One potential explanation for this result could be our assumption that the likelihood of an exogenous event requiring early redemption is the same for all ﬁrms. 8 Conclusion Make-whole call provisions have become quite common in corporate debt over the past ﬁve years. is strictly speculation. and exogenous requirements to retire debt early are taken into account. our model predicts that the average bond with a make-whole call provision should have a yield that is approximately 2. Nuttall (1999). In either case.1 bp. transactions costs. however. In a frictionless market environment. The alternative reason for the greater observed incremental yields for poorly rated make-whole call bonds is that investors are unneccesarily penalizing poorly rated make-whole call issuers. Extensive empirical analysis of at-issue credit spread data for a large 32 . Netter. our model indicates that the incremental yield should average approximately 6. ﬁnds that the likelihood of being a takeover target for UK quoted companies is greater for more levered and more poorly performing ﬁrms. This greatly reduces the interest rate risk that is associated with a potential future call.

an additional 5 bp in yield reduces oﬀering proceeds by $2. since 1954. a 7 percent coupon. In this environment.3 million . In practice. An additional 5 bp in yield may seem negligible. that our model likely overestimates what incremental yields should be. In dollar terms. we have only included imperfections that generate an increase in incremental yields. For example. for a representative par bond with 15 years to maturity.to us a sum that should not be casually disregarded. it is substantial when compared to the typical credit spread at origination of 125 bp. Moreover. our’s is an abstraction from reality and incremental yields are potentially predicted with error. could conceivably have the opposite eﬀect. indicates that the observed incremental yield is more than 11 bp. however. however. One reason why we believe this is because our underlying model is strictly a default model. 2001). Like all structural models. ensuring that even the most credit-worthy corporate bonds have yields that are signiﬁcantly greater than risk-free yields. We feel. corporate credit spreads incorporate other factors such as liquidity risk. however. however. and diﬀerential state taxation relative to Treasury securities (Elton et al. Our conclusion is that make-whole call provisions to date have been overpriced at origination and that issuing ﬁrms have been paying too high of a yield on their newly issued make-whole call bonds. however.sample of corporate bonds with make-whole call provisions. 33 . Alternative imperfections. systematic risk.. These other factors lend an additional component to credit spreads. the diﬀerence between observed and predicted incremental yields is statistically signiﬁcant. the typical make-whole call provision with a make-whole premium of 25 bp will have minimal economic value since it is almost always out-of-the-money. and an oﬀering amount of $500 million. The second reason why our model might overestimate incremental yields is that in the extended version. further strengthening our empirical results. Moody’s seasoned Aaa corporate bond yield has averaged 75 bp more than the 10-year Constant Maturity Treasury yield.

would be to apply our model to transactions data in a manner similar to that done by Duﬀee (1998) for bonds with ﬁxed-price call provisions. 1994). this is because at-issue data is signiﬁcantly cleaner. In addition. Thus. It is unclear whether this perceived pricing anomaly will continue. Primarily. Longstaﬀ (1992) for example. Without arbitrage opportunities. we assume a worst-case scenario when ﬁrms are exogenously required to tender for non-callable debt.For example. ﬁrms might delay calls due to transactions costs incurred when calling (Mauer. For make-whole call provisions we see little opportunity for arbitrage opportunities due to the incompleteness of the corporate bond market. For example. In addition. analysis of how make-whole call bond yields evolve relative to non-callable bond yields as characteristics 34 . This would enable us to determine whether the perceived mispricing persists in the after-market. however. or simply because a suboptimal call policy is employed (King and Mauer. Anything which delays calls beyond the point predicted by our model will necessarily reduce model-generated incremental yields. despite the apparent existence of arbitrage opportunities. and easily worked with than the sparse transactions data available for corporate bonds. Note that we test our model only against at-issue bond data. veriﬁable. concerns about wealth transfers resulting from temporary capital structure changes (Longstaﬀ and Tuckman. This is highly debatable when the investment is a corporate bond. there is no obvious mechanism that will drive down the at-issue incremental yield of make-whole call provisions. The ﬁnal reason why model-generated incremental yields might be too high is because we have been conservative in our assumptions regarding the three incorporated imperfections. 2000). shows that there has been persistent mispricing of ﬁxed-price call options on older Treasury securities. 1993). we assume that the marginal investor is taxed. An interesting extension for future research. the additional incremental yield due to both imperfections is likely to be overstated in the model.

t) = max {0. r(t). At the debt maturity date T . r. t + dt)]}. t) can be determined by maximizing the expected value of equity. t). and the macroeconomy change would improve our understanding of how these innovative call provisions are priced. the bond market.of ﬁrms. c. r) − M(r. the value of equity E is given as the solution to the following PDE: 35 . r) − F.1 Appendix Valuation of the unlevered ﬁrm The value of the unlevered ﬁrm V is given as the solution to the following PDE √ σ 2 s2 σ2r r Vrr + s Vss + ρσ s σ r s rVrs 2 2 + κr (r − r)Vr + (r − α)Vs + s − p − rV = 0. (21) Any time prior to maturity. 9 9. F. [s − p − c]dt (20) EQ [E(s(t + dt). T ) = max(V (s. over all possible call and default strategies: E(s(t). E(s. V ≥ 0. t < T. +e −r(t)dt max (V (s. the value of the ﬁrm’s equity is the greater of zero and the diﬀerence between the value of the ﬁrm’s assets and the par value. the value of equity E(s. r. The boundary condition V ≥ 0 reﬂects the ﬁrm’s option to shut down its operations as soon as its value becomes negative. and the price level s. ∗ (19) 9. r(t + dt).2 Valuation of the Equity Given the value of the short-term interest rate r. 0).

c. r) − M(r. r) > max(0. The call boundary (if applicable) should satisfy E(s. T )). E ≥ 0 (22) with additional free boundary conditions that characterize the boundaries where debt is called and where the ﬁrm defaults. F.√ σ2r σ 2 s2 r Err + s Ess + ρσ s σ r s rErs + κr (r∗ − r)Er + (r − α)Es + 2 2 + Et + s − p − c − rE = 0. (23) 36 . V (s.

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The columns display the nominal dollar amount of corporate debt issued in the U. not a Medium Term Note. fixed semi-annual coupon. not putable. not a Yankee bond. 42 . Included issues have the following characteristics: maturity of at least one year. not part of a unit offering.S. per year. and listed as a corporate debenture. not asset-backed. denominated in U. without a sinking fund. Note that the 2002 data stops at 10/01/2002. offering amount greater than $25 million.S. dollars.

All other parameters for the model are held fixed at base case values. 43 .Plot points show the model-generated incremental yield attributable to the make-whole call provision as a function of the make-whole premium.

022 (0.0049) .41) 30. Q: (total assets – book equity + market equity) divided by total assets.0004) . We allow one observation per firm.5%) 0.7%) 12. Sales Growth: 10 year average annual sales growth.9% (13. $10.8%) 14.758) 7.6%) 12.37) 31.0685 (. σ Sales Growth: standard deviation of 10 year annual sales growth.2%) 13.1% (26.6% (11.1% (29.0001) . EBITDA/MKT: earnings before interest.683) 8.2%) 12.Table 1 Panel A: Issuing Firm Characteristics. Columns five and six present results for the subset of bond issuers where we were able to calculate a model-generated credit spread.8% (11.0090 (.4% (11.5278) .4% (30.0000 (.0001 (.9% (9.021) 435 44 .8%) 0.2%) 11. Initial Sample Straight Make-whole Sales EBITDA/MKT EBITDA/AT Q Book Leverage Sales Growth σ Sales Growth Equity Volatility # of Obs.1%) 1.0001) .1% (8. per bond type.34) 23.9804) . EBITDA/AT: EBITDA divided by total assets.0016 (.0% (13. Columns two and three present results for the entire universe of straight bond and make-whole call bond issuers screened from the FISD.5% (9.6%) 1.0%) 0.5% (13.020 (0.5%) 12. per year.017) 520 $8. Equity Volatility: standard deviation of daily excess stock return for the prior 6 months.9%) 10.988 ($4.63 (1.019 (0.58 (1. Data definitions: Sales: total firm sales.2% (24.797 ($4. Means (medians) for issuing firm characteristics.0009 (.0000) Final Sample Straight Make-whole $10.0001) .1%) 1.6% (8.145) 8.76 (1.4% (7.9% (8.58 (1. and depreciation divided by market value of firm.020) 1083 T-test (Rank-Sum) .5%) 0. Column four displays p-values for a T-test and a Wilcoxon Rank-Sum test comparing straight issuers to make-whole issuers from columns two and three.0% (11.3% (8.3%) 16.0185 (.32) 28.0195 (.0%) 1.712 ($3.3% (9. Book Leverage: long-term debt divided by total assets.4%) 13.415) 8.017) 966 $7.1% (11.3%) 16.022 (0. taxes.111 ($3.3%) 15.

0001 (.2 (10.1 (10.Panel B: Bond Characteristics.).583 T-test Rank-Sum .4909 (.0) (9.0) $365 (281) 180 bp (163 bp) 734 45 .612 13.0001 (. Data definitions: Rating: ordinalized bond rating (AAA = 1. AA+ = 2.0) (9. Maturity: years to maturity.0 8.0) $403 ($250) 117 bp (88 bp) 1.0 (10. Offering Amount: total face value in millions of nominal dollars.0001) .0001) .0 8.3 (7.0001) . Initial Sample Straight Make-whole 7.0) $392 ($300) 179 bp (155 bp) 1.0001) Final Sample Straight Make-whole 7.0) 10.0) 11.0) $336 ($244) 108 bp (88 bp) 775 12.5 (7. etc.7 (9. Rating Maturity Offering Amount Offering Spread # of Obs. Offering Spread: actual yield-to-maturity at issue minus the equivalent maturity Constant Maturity Treasury yield.0001 (.

For make-whole call bonds. with the exception of the make-whole call provision.75 bp (1. Relative Prediction Error is Prediction Error divided by observed Offering Spread and σ Relative Prediction Error is the associated standard deviation. is equivalent in all respects. 775 46 . Non-callable Signed Absolute Value Value 81 bp (38 bp) -26 bp 81 bp (-44 bp) (67 bp) 98 bp 61 bp -18% (-60%) 106% 85% (87%) 65% Make-whole Signed Absolute Value Value 145 bp (114 bp) -35 bp 104 bp (-48 bp) (89 bp) 127 bp 80 bp -10% (-31%) 81% 2. Both signed values for errors and absolute values are presented.75 bp) 612 64% (63%) 49% Predicted Spread Prediction Error σ Prediction Error Relative Prediction Error σ Relative Prediction Error Incremental Yield # of Obs. Predicted Spread incorporates the inclusion of a make-whole call provision. Incremental Yield is reported only for make-whole call bonds and is the Predicted Spread for the make-whole call bond minus the Predicted Spread for a straight bond that.Table 2 Model-Generated Credit Spreads Predicted Spread is the model-generated yield-to-maturity minus the model-generated risk-free rate. Prediction Error is Predicted Spread minus observed Offering Spread and σ Prediction Error is the associated standard deviation.

yield of model derived 10 year risk-free note (Yield Curve Level) = 5. The model-generated Credit Spread for the base case non-callable bond is 65.037 0. for example Premium.16% 4.89 bp. The low and high values for the respective parameters roughly correspond to 25th and 75th percentile sample values.26 bp 4.93 bp Incremental Yield 2.82 bp 0.04 bp 84.4%.21 bp 30 bp 65.44 bp 3.4% +1% -1% -0.59 bp 56.33 bp 4.62 bp 3.64%.91 bp 71.13 bp 3.88 bp 47 . payout rate of firm (Alpha) = 4. Each row of the table reports the Credit Spread and Incremental Yield as one of the parameters.16 bp 72.04 bp 42.077 58.5% 4.49 bp 5.27 bp 3. correlation of stochastic processes for risk-free rate and cash flows (Stochastic Correlation) = 0.95 bp 38. is varied below and then above the base case value.Table 3 Comparative Statics The model parameters for the base case bond are as follows: make-whole premium (Premium) = 0 bp for base case non-callable bond and 24 bp for base case make-whole call bond.41 bp 78.5%.24 bp 27.21 bp 8 yrs 15 yrs 14.16 bp 67.95 bp 170.61 bp 3.76% 8. 10 year historical variance of annual sales (Sales Volatility) = 11.83 bp 3.027.33 bp 5.95 bp 2.5% 22. Parameter Premium: Maturity: Leverage: Alpha: Sales Volatility: Yield Curve Level: Stochastic Correlation: low value Credit high value Spread 18 bp 65.78 bp 4. Maturity = 10 years. long-term debt divided by total assets (Leverage) = 18.21 bp and the Incremental Yield of the equivalent make-whole call bond is 3.4% 17.56%.24 bp 62.

MW_IYm is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.020 (0.57)*** 0. 5% and 1% levels is denoted by *.54)*** 0.76)*** 0.094 (3. zero otherwise.79)*** -0.610 (4.257 (12. Specification 1 is OLS while 2 and 3 are robust OLS (weighted least squares is used to limit impact of outliers).74)*** -0.184 (19.76)*** 3. Constant NC_CSpm MW_IYm Baa_CMT_Sp Residual Rating Not Rated Rule 144A Finance Utility Log Maturity Log Offering Amt First Bond Senior Equity Volatility # of OBS Adj. ***. zero otherwise.031 (19.047 (2.062 (4.731 (28.556 (2.34) 0.184 (18. zero otherwise.329 (10. Senior is coded one if the bond is denoted senior or senior-secured.14)*** 0.76)*** -0. zero otherwise.126 (20.80)*** 0. it is the credit spread of an equivalent straight bond.32)*** -0.750 (13. Rule 144a is coded one for privately issued bonds. MW is coded one for bonds with a make-whole call provision. Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield.149 (3. Residual Rating is the difference between actual ordinal rating of the bond and a predicted rating obtained via an ordered logit regression (see text for details).19)*** 0.080 (1.56) Spec. zero otherwise.443 (8.40) 0.018 (0.40) 0.48)*** 0.10)** 0.90)*** 0.6169 1339 .6458 48 .35) 0.104 (2.684 (27. Independent variables are as follows.153 (17.006 (0.62)*** -0. 2 -0.30) 0.135 (8.05)*** 1339 .129 (23.52)*** -0.018 (0.046 (2. respectively.05)*** -0.866 (8.72)** 0. 3 -0.Table 4 Empirically Observed Credit Spreads Versus "Pure" Model-Generated Values The dependent variable is the bond's actual credit spread at issue.097 (3. respectively.492 (4.107 (6. First Bond is coded one when the observation represents the first bond issue for the firm.509 (20.134 (2.41) -0. R2 1339 .52)** 0.07)*** 0.22)*** 6.144 (4.219 (6.07)*** -0.46)*** 0. Below each coefficient estimate is the t-statistic (for specification 1 the t statistics are calculated using White standard errors.98)*** 0. Finance and Utility are coded one for financial services and utility firms. For make-whole call bonds.075 (0.5647 Spec.16)*** 4.359 (8.385 (11.467 (7.81)*** 0.18)*** 30. Equity Volatility is standard deviation of the firm's excess stock returns for the 183 days prior to the offering.) Significance at the 10%.390 (1. **.081 (2.02)*** Spec.48)*** 0. NC_CSpm is the model-generated credit spread for a non-callable bond. Not Rated is coded one for unrated bonds.01)** -0. 1 0.08)*** -0.99)*** 0. zero otherwise.

with the exception of the make-whole call provision. Incremental Yield is reported only for make-whole call bonds and is the Predicted Spread for the make-whole call bond minus the Predicted Spread for a straight bond that. Prediction Error is Predicted Spread minus observed Offering Spread and σ Prediction Error is the associated standard deviation.07 bp (5. Relative Prediction Error is Prediction Error divided by observed Offering Spread and σ Relative Prediction Error is the associated standard deviation. Both signed values for errors and absolute values are presented.Table 5 Model-Generated Credit Spreads Incorporating Imperfections Predicted Spread is the model-generated yield-to-maturity minus the model-generated risk-free rate. 775 49 . Straight Absolute Value 81 bp (37 bp) -27 bp 81 bp (-44 bp) (67 bp) 97 bp 61 bp Signed Value -19% (-60%) 105% 85% (85%) 64% Make-whole Signed Absolute Value Value 147 bp (117 bp) -33 bp 102 bp (-45 bp) (86 bp) 125 bp 80 bp -9% (-29%) 79% 6.44 bp) 612 63% (61%) 49% Predicted Spread Prediction Error σ Prediction Error Relative Prediction Error σ Relative Prediction Error Incremental Yield # of Obs. For make-whole call bonds. Predicted Spread incorporates the inclusion of a make-whole call provision. is equivalent in all respects.

507 (20.75)*** 0.10) 0. For make-whole call bonds.04)*** -0.148 (4. it is the credit spread of an equivalent straight bond.67)*** 3.386 (11. zero otherwise. Finance and Utility are coded one for financial services and utility firms respectively. zero otherwise.Table 6 Empirically Observed Credit Spreads Versus Model-Generated Values with Imperfections The dependent variable is the bond's actual credit spread at issue.476 (7.146 (8.75)*** 0.044 (1. MW_IYm is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.55) 0. Independent variables are as follows.13) 0.50)*** 2.76)* Spec 3.01)*** 0.393 (8. Constant NC_CSpm MW_IYm Baa_CMT_Sp Residual Rating Not Rated Rule 144A Finance Utility Log Maturity Log Offering Amt First Bond Senior Equity Volatility # of OBS Adj. Below each coefficient estimate is the t-statistic (for specifications 1 the t-statistic is calculated using White standard errors.39)*** 30.176 (19.93)*** 0.91)*** -0.582 (2.89)*** -0. 5% and 1% levels is denoted by *. NC_CSpm is the model-generated credit spread for a non-callable bond. **.23)*** -0. -0.62)*** -0.004 (0.124 (0.065 (2.159 (3. Senior is coded one if the bond is denoted senior or senior-secured. respectively. zero otherwise.59)*** 0. R2 1339 .331 (1.089 (3.60)*** 0.738 (13.22)*** 0.242 (11.03)*** 1339 .734 (18.101 (3.58) -0.88)*** -0.85)*** 0.12)*** 0.36)*** 0. ***.158 (17.99)** 0.587 (4.65)*** 0.12)*** Spec.26) 0.17)** 0.129 (21.24)*** 0.005 (0.66)*** -0.07 (19.505 (4.131 (23.63)*** 0.025 (0. Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield.80)*** -0.15)*** 2.6129 1339 .059 (3. zero otherwise.) Significance at the 10%.146 (3.83)*** 0.090 (2.119 (6.328 (10.091 (1.64)*** -0.176 (17. Rule 144a is coded one for privately issued bonds.076 (2.64)*** -0. Equity Volatility is standard deviation of the firm's excess stock returns for the 183 days prior to the offering. Not Rated is coded one for unrated bonds.66) 0.682 (27. MW is coded one for bonds with a make-whole call provision.239 (5. 2 -0.5618 Spec. 1 0. zero otherwise.036 (0.433 (8. zero otherwise. Residual Rating is the difference between actual ordinal rating of the bond and a predicted rating obtained via an ordered logit regression (see text for details).85)*** 0.130 (8.6421 50 . First Bond is coded one when the observation represents the first bond issue for the firm. Specification 1 is OLS while 2 and 3 are robust OLS (weighted least squares is used to limit impact of outliers).

it is the credit spread of an equivalent straight bond. specification 3: matched subset of the sample where make-whole and straight bonds have been matched on the basis of rating.5178 0. MW_IYm is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.105 (1.11)*** 0.30) 0.133 (13.091 (13.118 (0.47)*** 0. zero otherwise.34)*** 0.57)*** 0. Not Rated is coded one for unrated bonds. Below each coefficient estimate is the t-statistic. 2 -0.45)*** 2.16)*** 0.6184 0.5643 Spec. All specifications are robust OLS (weighted least squares is used to limit impact of outliers).96)*** 0.275 (7. Finance and Utility are coded one for financial services and utility firms.27)** 0.79)*** 0.95)*** 0. Senior is coded one if the bond is denoted senior or senior-secured.98)** 1126 .33)*** Spec.92)*** 0. specification 4: bonds issued by firms that are represented by at least one straight bonds and at least one make-whole call bond in the sample. Rule 144a is coded one for privately issued bonds. zero otherwise.08)*** -0.109 (1. zero otherwise.14)*** 0.Table 7 Robustness Checks for Empirically Observed Credit Spreads The dependent variable is the bond's actual credit spread at issue. Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield.693 (22.169 (4.127 (2.86) 0.46) 0. ***. zero otherwise.75)*** 0. specification 2: Rating of Baa.145 (7.84)* 815 . MW is coded one for bonds with a make-whole call provision.34) 0.02)*** -0.643 (24.33)*** 548 .699 (31.42)** 779 . 5% and 1% levels is denoted by *.202 (2.45)*** -0.004 (0. 4 0.145 (11. For make-whole call bonds.19)*** 0.150 (8.90)*** -0. Constant NC_CSpm MW_IYm Baa_CMT_Sp Residual Rating Not Rated Rule 144A Finance Utility Log Maturity Log Offering Amt First Bond Senior # of OBS Adj.222 (0. 1 -1.153 (5.93)*** 0.659 (2.613 (20.93) -0.286 (8.53)*** 2. Significance at the 10%.601 (1. First Bond is coded one when the observation represents the first bond issue for the firm. The subsamples for each regression are as follows: specification 1: rating of Baa.037 (0.58)*** 0.21) 0.184 (5.098 (1. respectively.673 (9.64)*** -0.89)*** Spec. zero otherwise.152 (11. Independent variables are as follows.140 (2.009 (5.79)*** 2. zero otherwise.187 (4.112 (5.043 (0.95)*** Spec.363 (9.or better. Residual Rating is the difference between actual ordinal rating of the bond and a predicted rating obtained via an ordered logit regression (see text for details).027 (1. respectively. NC_CSpm is the model-generated credit spread for a non-callable bond.79) 0.65)** 0.52) 0.26) 0. maturity and industry group. 3 -0.750 (7.152 (9.6046 51 .462 (7.092 (7.787 (12.094 (15.67)*** 0.or better and excluding bonds issued by finance or utility companies.19)** -1.043 (5.034 (1.134 (17.68)*** -0. **.60) 0.00)*** 0.17)*** 2.007 (0.140 (4.093 (12.42)*** 0.185 (14. R2 0.

it is the credit spread of an equivalent straight bond.22)** 887 452 .115 (13.54)*** 0.314 (8.43) -0.72) 0.673 0. 5% and 1% levels is denoted by *.41)*** (9.62) (4.45) (0.828 (7.92)*** (3.34)*** (7.35) 0.55)*** (6. 3 Good Rating Poor Rating -1. respectively.90)* (4. **. 1 Early Late -0.217 (14.23) (1.10)*** (4.16)*** 0.092 (0.998 (5.000 -0.00) (2.485 (5.03)*** 0.007 -0.27)*** -0.177 (9.58)*** 0.035 0.354 0.162 0.28) (1.024 (0.07) 0.093 0. For make-whole call bonds.Table 8 Split Sample Comparisons The dependent variable is the bond's actual credit spread at issue.32)*** 0.982 -0. zero otherwise.03) -0.78)*** (6. MW_IYm is the model generated make-whole call provision incremental yield and is set to zero for straight bonds.43)*** (0.064 (0.35)*** (0. Constant NC_CSpm MW_IYm Baa_CMT_Sp Residual Rating Not Rated Rule 144A Finance Utility Log Maturity Log Offering Amt First Bond Senior # of OBS Adj.25)*** 0.290 (11.031 0. NC_CSpm is the model-generated credit spread for a non-callable bond. respectively.92)*** 810 .27) 0.253 (6.95)*** 2.029 (0.189 (0. zero otherwise. the sample is split into bonds issued before versus after 10/1/1999.843 (6.01)*** -0.1 years.73)* 0.674 (16.001 (0.244 -1.35)** -0.33)*** (3.005 (0. the sample is split into bonds with ratings of Baa+ or better versus Baa or worse. All specifications are robust OLS (weighted least squares is used to limit impact of outliers). Not Rated is coded one for unrated bonds. Baa_CMT_Sp is Moody's seasoned Baa yield minus the 10-year CMT yield.68)*** 0.016 (4. Long Mat.071 (3.70)* (2.027 (1.707 0.79)*** (21.031 (5. zero otherwise.090 (1.113 (3.16)*** -0.668 3.137 1.85)* -0.116 0.16)*** 2.6073 Spec.98) 0. Rule 144a is coded one for privately issued bonds.30) 539 800 .150 0.202 (3. zero otherwise.02)*** 0. 0. For specification 3. First Bond is coded one when the observation represents the first bond issue for the firm. For specification 1.135 0. ***.147 (2.16)*** (14. 2 Short Mat.180 (22.18)*** (6. Senior is coded one if the bond is denoted senior or senior-secured.160 (1.46)*** 0.5717 52 .136 0.202 0.469 (11.09)*** (0.90)*** -0.03)*** 0.57)*** (1. R2 Spec. Below each coefficient estimate is the t-statistic Significance at the 10%.860 (28.94)*** -0.124 (3.135 0.057 (1.159 (10.022 0.054 (24.62)*** 1.080 0.29)*** -0.665 0.12)*** 0.170 (6.166 0. Finance and Utility are coded one for financial services and utility firms.491 (7. the sample is split into bonds with maturity less than versus more than 10.225 (12.4517 Spec.84)*** (0.523 (2.147 (1.303 (0. Residual Rating is the difference between actual ordinal rating of the bond and a predicted rating obtained via an ordered logit regression (see text for details).52)*** (5.107 0.46)*** 0.73) 0.103 (2.39)*** (9.63) 0.39)*** 0.12)** 0.5821 . For specification 2.491 (10.60)*** 0.209 2.697 (5.80)*** 0.55)*** (7.626 3.684 -0.76)*** (15.52)*** (10.23)*** (10.92)*** 458 .085 0.09)*** (6.28)*** 0.182 (8. MW is coded one for bonds with a make-whole call provision. zero otherwise.106 0. zero otherwise.6361 0.45)*** (14.690 (3.82)*** -0.551 -0.5532 .80)*** 0. Independent variables are as follows.478 0.47) (4.88) -0.

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