Abstract
This paper uses a model of the valuation of bonds bearing call options, together with observed market yields on callable bonds, to infer information about the uncertainty associated with interest rate expectations. A dynamic programming solution of the model simultaneously determines both the bond price and the issuer's optimal refunding strategy, given the relevant data describing the bond and the market's expectations of future interest rates. Application of the valuation model in reverse, for quarterly average data for 1969-76, generates a time series representing the uncertainty which the market associated with its expectations of future interest rates during this interval, given the then-prevailing yields on new issues of utility bonds and industrial bonds callable after 5 years and 10 years, respectively. This uncertainty, parameterized as the standard deviation of a truncated normal distribution, fluctuated between 1/2 percent and 3/4 percent between 1969 and early 1974, then rose to sharply higher...
Highlights
Long-term corporate bonds issued in the United States are almost always callable by the issuer, with the exercise price of the call option specified in advance in the terms of the bond indenture
Yield and yield spread data and solution values for interest rate uncertainty there is a unique standard deviation for which a given coupon rate renders the bond's new-issue price equal to 100. What makes this problem somewhat difficult is that the relevant future interest rate which is equivalent to the discounting factor Pt in the model of Section II is the yield on a noncallable long-term bond
To the extent that this widening yield spread was related to the market's evaluation of the differences between the call provisions of these two kinds of bonds, the valuation model indicates a sharp increase in uncertainty about the course of future interest rates
Summary
Long-term corporate bonds issued in the United States are almost always callable by the issuer, with the exercise price of the call option specified in advance in the terms of the bond indenture. The U.S corporate bond market, which has increasingly favored standardized indenture terms for public issues as a means of enhancing the bonds' ready tradability, has developed several conventions pertaining to the call features of corporate bonds Among such standardized practices, the time length of the deferment restriction is relevant to this paper's analysis.. Market provides bonds with substantially longer formal call protection; the call option on most long-term Treasury issues is restricted to the last 5 years before the bond's maturity date. Given this breadth of investor choice, the market inevitably prices the different securities in a way which reveals preferences for one security versus another.
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