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Standard approaches to building and estimating dynamic term structure models rely on the assumption that yields can serve as the factors. However, the assumption is neither theoretically necessary nor empirically supported. This article documents that almost half of the variation in bond risk premia cannot be detected using the cross-section of yields. Fluctuations in this hidden component have strong forecast power for both future short-term interest rates and excess bond returns. They are also negatively correlated with aggregate economic activity, but macroeconomic variables explain only a small fraction of variation in the hidden factor. [ABSTRACT FROM PUBLISHER]

We analyze the empirical power and specification of test statistics designed to detect abnormal bond returns in corporate event studies, using monthly and daily data. We find that test statistics based on frequently used methods of calculating abnormal monthly bond returns are biased. Most methods implemented in monthly data also lack power to detect abnormal returns. We also consider unique issues arising when using the newly available daily bond data, and formulate and test methods to calculate daily abnormal bond returns. Using daily bond data significantly increases the power of the tests, relative to the monthly data. Weighting individual trades by size while eliminating noninstitutional trades from the TRACE data also increases the power of the tests to detect abnormal performance, relative to using all trades or the last price of the day. Further, value-weighted portfolio-matching approaches are better specified and more powerful than equal-weighted approaches. Finally, we examine abnormal bond returns to acquirers around mergers and acquisitions to demonstrate how the abnormal return model and use of daily versus monthly data can affect inferences. [ABSTRACT FROM PUBLISHER]

I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. It features a flexible and tractable affine structure for bond covariances. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid–ask spread. Furthermore, market prices of interest rate caps do not deviate significantly from their no-arbitrage values implied by the swaptions under the model. These findings support the conjectures of Collin-Dufresne and Goldstein (2003) , Dai and Singleton (2003) , and Jagnnathan, Kaplin, and Sun (2003) . [ABSTRACT FROM AUTHOR]

Most existing dynamic term structure models assume that interest rate derivatives are redundant securities and can be perfectly hedged using solely bonds. We find that the quadratic term structure models have serious difficulties in hedging caps and cap straddles, even though they capture bond yields well. Furthermore, at-the-money straddle hedging errors are highly correlated with cap-implied volatilities and can explain a large fraction of hedging errors of all caps and straddles across moneyness and maturities. Our results strongly suggest the existence of systematic unspanned factors related to stochastic volatility in interest rate derivatives markets. [ABSTRACT FROM AUTHOR]

The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. [ABSTRACT FROM AUTHOR]

This article presents a discussion on the effectiveness of realized returns to establish expected returns. The author argues that realized returns are a poor measure of expected returns and points to the existence of various anomalous results and to evidence from U.S. and Asian markets that affirm this point. He suggests that there is a need to develop better measures of expected returns and ways to test asset pricing theories that do not require the use of realized returns, which can provide skew results. To do so he examines the expected returns on government bonds.

This study examines the initial-day and aftermarket price performance of corporate straight debt IPOs. We find that IPOs of speculative grade debt are underpriced like equity IPOs, while those rated investment grade are overpriced. IPOs of investment grade debt are typically issued by firms listed on the major exchanges and under-written by prestigious underwriters. In contrast, junk bond IPOs are more likely to be handled by less prestigious underwriters and are typically issued by OTC firms. Our analysis also reveals that bond rating, market listing of the firm, and investment banker quality are significant determinants of bond IPO returns. [ABSTRACT FROM AUTHOR]

We develop a method of measuring ex-ante real interest rates using prices of index and nominal bonds. Employing this method and newly available data, we directly test the Fisher hypothesis that the real rate of interest is independent of inflation expectations. We find a negative correlation between ex-ante real interest rates and expected inflation. This contradicts the Fisher hypothesis but is consistent with the theories of Mundell and Tobin, Darby and Feldstein, and Stulz. We also find that nominal interest rates include an inflation risk premium that is positively related to a proxy for inflation uncertainty. [ABSTRACT FROM AUTHOR]

A new empirical model for intertemporal capital asset pricing is presented that allows both time-varying risk premia and betas where the latter are identified from the dynamics of the conditional covariance of returns. The model is more successful in explaining the predictable variations in excess returns when the returns on the stock market and corporate bonds are included as risk factors than when the stock market is the single factor. Although changes in the covariance of returns induce variations in the betas, most of the predictable movements in returns are attributed to changes in the risk premia. [ABSTRACT FROM AUTHOR]

The effects of asset liquidity on expected returns for assets with infinite maturities (stocks) are examined for bonds (Treasury notes and bills with matched maturities of less than 6 months). The yield to maturity is higher on notes, which have lower liquidity. The yield differential between notes and bills is a decreasing and convex function of the time to maturity. The results provide a robust confirmation of the liquidity effect in asset pricing. [ABSTRACT FROM AUTHOR]

This study extends the literature on the pricing of low-grade bonds by examining the performance of low-grade bond funds. The findings reveal that over the long run low-grade bond fund returns are approximately equal to the returns provided by an index of high-grade bonds. The relative risks of high and low-grade bonds are more difficult to assess. Because of their shorter durations, low-grade bonds are less sensitive to movements in interest rates than high-grade bonds. On the other hand, low-grade bonds are much more sensitive to changes in stock prices than high-grade bonds. When adjusted for risk using a simple two-factor model, the returns on low-grade bond funds are not statistically different from the returns on high-grade bonds. [ABSTRACT FROM AUTHOR]

Empirical evidence of time varying term premia in bond returns is frequently interpreted as evidence against the Expectations Hypothesis. This paper shows that the Expectations Hypothesis can actually imply time varying term premia if the time frame for which the Expectations Hypothesis holds differs from the return measurement period. Furthermore, many of the properties of these term premia are consistent with those of observed term premia. These results are important because they imply that the case against the Expectations Hypothesis is weaker than claimed in the empirical literature. [ABSTRACT FROM AUTHOR]

The pricing of newly issued bonds on the Swiss capital market is investigated over the years 1980-1982. The results reveal a slight underpricing of new bonds at the issue date that is roughly equal to the difference in transactions costs between the markets for new and seasoned bonds. Underpricing is no longer observed when the new bonds start to be traded on the stock exchange, that is, after about two days. Tests of several hypotheses show that unexpected changes in interest rates over the offering period explain part of the underpricing. [ABSTRACT FROM AUTHOR]

In this paper, we develop a model for valuing debt options that takes into account the changing characteristics of the underlying bond by assuming that the standard deviation of return is proportional to the bond's duration. The resulting model uses the bond price as the single state variable and thus preserves much of the simplicity and robustness of the Black-Scholes approach. The paper provides comparisons between option prices computed using this model and those using the Black-Scholes and Brennan and Schwartz models. [ABSTRACT FROM AUTHOR]

This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax-free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break-even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds. [ABSTRACT FROM AUTHOR]

This paper analyzes the effect of expected inflation on nominal interest rates, in a theoretical model with money and two different bond types. The inclusion of three assets instead of the usual two causes the effect of expected inflation on the interest rates to deviate from unity. Depending on the sizes of the wealth and interest rate effects on the various asset demands, the effect of expected inflation could even be negative. Several special cases are also considered, and the implications for the interpretation of empirical results are discussed. [ABSTRACT FROM AUTHOR]

Default free bonds represent, in essence, money sold forward: the investor gives dollars (say) to the Government now in exchange for a contract which promises to pay, with probability one, a given number of dollars at maturity, and possibly a stream of intermediate coupon payments prior to maturity. Only recently have financial economists begun to examine the pricing of those bonds in a portfolio context. In that framework, nominal "liquidity premiums" or risk premiums on long-term default-free bonds are attributable to uncertainty about taste, technological, and price level changes which may occur prior to maturity of the bonds (and prior to each coupon payment if any). To the extent that the investor is unable to diversify away that uncertainty, there is a systematic risk attached to the marginal utility which he or she can derive from the use in consumption or investment of the dollar payoffs on the bonds. In some term structure models, the instantaneous or "short-term" rate of interest, denoted here as a function of time t by R(t) in nominal terms and r(t) in real terms, can be taken as a sufficient statistic for the source of systematic uncertainty about the marginal utility of the proceeds to be derived from default-free bonds maturing beyond the next instant (e.g., Merton [1974], Vasicek [1977], Cox, Ingersoll, and Ross [1977]). Specific assumptions about tastes, technology, and utility functions lead to specific equilibrium stochastic processes for the instantaneous (short-term) riskless rate, and longer term bond prices which are modelled as functionally dependent upon maturity and that short term riskless rate. If a closed form solution exists for the long-term bond price as a function of maturity and the short term interest rate, it will be conditional, inter alia, on the parameters of the stochastic process for that short term rate. Marsh [1981] proposed that the closed form solutions could be tested in terms of the restrictions implied cross-s... [ABSTRACT FROM AUTHOR]

This preliminary investigation of relative risk in municipal and corporate bonds reveals that in at least two respects they are remarkably similar. First, the measured variances of return for portfolios of comparably rated bonds are virtually identical. Second, the covariances of comparably rated bond portfolios with an index of common stock returns are also very close to one another. Some have argued that because municipals are risker than corporates, the yield ratio (municipal to corporate) understates the actual marginal tax bracket at work across the bonds. But since these risk differences are not discernable, the relative yields may be truly informative about the tax brackets of the marginal holders of the bonds. Of course, the standard deviation of return and the covariance of return with a common stock index are not necessarily proper measures of risk. A complete answer to the relative risk question will only be possible in the context of a complete model of risk and return. [ABSTRACT FROM AUTHOR]

The article discusses the problems with the conclusion that because the yields to maturity on municipal bonds are generally more volatile than those on taxable bonds, the prices of municipal bonds are more volatile than those of taxable bonds. The article states that to compare the price changes of taxable and nontaxable bonds in response to interest rate changes, it is necessary to consider both premium and discount bonds and the taxation of losses of bonds and capital gains for both individuals and banks. The article provides proofs for four cases.

This paper examines the adjustments in a firm's common stock price during the eleven months before and during the month of announcement of a bond rating change. Based on several different measures of abnormal security return, the findings are consistent with the proposition that bond downgradings convey information to common stockholders. For bond upgradings, the price adjustments were statistically insignificant in the month of announcement, although in the eleven preceding months, upgraded firms exhibited positive abnormal returns. While the results do not fully support earlier research, we stress that the main contribution of this article lies in the scrutiny it gives to issues of methodology in assessing the possible price effects of bond reclassifications. [ABSTRACT FROM AUTHOR]

There have been a number of studies of the price/yield behavior of newly-issued corporate bonds. These studies find that there are systematic differences in yield to maturity between newly-issued bonds and bonds that have been outstanding for some time. Typically, new issues have higher yields and these differences are usually found to persist for some time after issue. Authors realize that such differences are inconsistent with an efficient bond market and usually explain these differences by appeal to various assumed market imperfections, such as a "thin" market in seasoned issues. In this paper we approach the question of differences between new and seasoned issues by concentrating on holding-period returns (coupon plus capital gain) instead of the more usual yield to maturity. That is, we ask whether there are differences in holding period returns between seasoned and unseasoned bonds. The paper is organized as follows: Section I briefly surveys the literature on the seasoning process and develops our approach; Section II develops the hypotheses and describes our test procedure; Section III describes the data used and the results of our tests and Section IV discusses the implications of our findings. [ABSTRACT FROM AUTHOR]

A common statistic for a bond is its market yield or internal rate of return. Numerous articles have been written utilizing the internal rate of return to examine the price volatility of bonds. However, all these studies have two factors in common. One, they are nonstochastic and two, they involve Macaulay's duration. This paper, by introducing uncertainty, derives the general relationship between the expected return on a bond and its market yield. The derivation is for risky corporate as well as for default free government bonds. The relationship is nonlinear and involves an expression which is an approximation to the duration of a bond. As a corollary to the above methodology, an alternate expression for the systematic risk of a bond is discovered. The expression involves only the market yield and the approximation to a bond's duration. This corollary generalizes the previous work of Boquist, Racette, and Schalarbaum in two respects. First, this paper's formulation is for any type of a bond, while Boquist, et al. examined only default free securities. Second, the single period capital asset pricing model (CAPM) is replaced by its intertemporal counterpart as formulated by Merton. An outline for the paper is as follows. Section I derives the relationship between a bond's market yield and expected return. Section II examines the systematic risk of a bond, while Section III concludes the paper. [ABSTRACT FROM AUTHOR]

Theory suggests that two bonds which are comparable in all respects should offer investors the same yield. However, the yields of new corporate bonds often differ substantially from almost identical seasoned (outstanding) bonds. The most extensive work investigating this difference in yields between new and seasoned bonds (yield spread) was done by Conard and Frankena (3). Their primary finding was that differences in coupon rates between new and seasoned bonds of equal quality (Aa Public Utility) accounted for about one-half the yield spread. Because of this finding, equal quality new and seasoned bonds with the same coupon rates are used in the present study. [ABSTRACT FROM AUTHOR]

The article presents comments on the article "The Expected Holding Period Return, Uncertainty and the Term Structure of Interest Rates" by John S. McCallum, published within the issue. The author voices some criticisms of the hedging pressure model employed in McCallum's research, chiefly that the model fails to incorporate interest rate risk. He asserts that McCallum fails to incorporate the central issue of uncertainty into his argument, but nonetheless clarifies the limitations of the market model and betas used in this context.

The article discusses the factors that regulate the price volatility of bonds and how that is determined by yield volatility and the duration of payments. The paper argues that economic information plays an important role in figuring out a bond's price volatility. It is noted that historical market information is needed in order to create an accurate idea of how bond maturity impacts volatility. The article concludes that bond duration and yield volatility can be used as factors to calculate price volatility.

To date, a number of studies involving the use of bond prices and/or returns have utilized the published prices of trades on the New York and other exchanges. These exchange quotes reflect the odd-lot activities of individual investors and account for only a negligible portion of the trading in listed issues. In contrast, the vast majority of listed corporate trading occurs over-the-counter and involves round-lot trades between institutions. Given differences in market characteristics, odd-lot exchange prices may differ substantially from those in the round-lot institutional market. This study compares exchange quotations from Moody's Bond Record with prices assigned by Merrill Lynch's institutional pricing service and uses each set of prices to calculate return and risk measures. Institutional (Merrill Lynch) bond prices are shown to be systematically greater than exchange (Moody's) prices. In addition, bond returns based on Merrill Lynch prices are shown to yield significantly higher beta and R² estimates, as well as significantly lower standard deviation and residual risk estimates. [ABSTRACT FROM AUTHOR]

In this paper prices of corporate bonds are decomposed into elements associated with (1) the pure price of time, (2) the default risk of the agency rating class to which the bond is assigned, and (3) the unique risk and ancillary features of the bond itself. [ABSTRACT FROM AUTHOR]

The article considers the pricing of premium bonds. The author seeks to determine the appropriate bond pricing equation for premium bonds under the assumption that taxpayers elect the amortization of the premium on a straight line basis as a deduction from regular taxable income. The author asserts that there are two parts of a bond pricing equation—one for discounts and par bonds and another for premium bonds. Additionally, the author discusses the coupon effect on yield to maturity and disproves Caks' method for deriving zero coupon discount rates from bond pairs.

The article reviews and evaluates investment research on bond price fluctuations and risk assessment of interest rate shifts since 1973. A definition of duration as a means to measure price change characteristics outside of maturity is given, highlighting its quantification of time needed for a bond to reach present value return. Common uses of duration are cited, such as its use as a risk proxy and for profitability analysis. Criticisms are also given to previous interpretations due to restrictive condition assumptions and econometric flaws. Correctional factors are reincluded to provide a revised definition for a risk measure of general interest rate shifts.

The article discusses the evaluation of convertible bonds. Two aspects in particular are analyzed--the effect of the "bond floor" on risk premiums, and how unpredictable and involuntary termination of convertibles affects their range of possible returns. The authors describe the market model for valuing convertible securities, note its shortcomings, and then introduce a simulation method for valuation that employs Monte Carlo methods. Among their findings is that conventional methods overstate the bond floor's contribution to value.

The article examines the impact of bond coupons on the yield to maturity. Previous research has identified a "coupon effect" wherein the yield on a multiple-period security depends on the coupon, unless equality prevails among all expected, one-period rates. The author presents analysis that demonstrates under what circumstances the coupon effect will be positive or negative. He also shows how conditions of market equilibrium are consistent with differences in yield among multiple-period securities.

This article discusses that the no-change forecast decidedly outperforms the "unconditional predictions" of long-term interest rates. Those who work in the capital asset pricing framework of modern finance theory tend to treat the term premium, which is related to the covariance of bond returns and the return to the market portfolio, as constant over time. Many of those who have conducted empirical studies of the determinants of term premiums have concluded that they may well be time-invariant. In the absence of convincing evidence of the existence of time-varying term premiums, and in view of the strong a priori belief in market efficiency, the success of the "no-change" prediction in the forecasting experiments conducted by economists is not surprising.

The article extends the results of an earlier paper by Boquist, Racette, and Schlarbaum on the relationship between risk and Macaulay's duration. The Boquist paper derived an expression for a bond's riskiness that was a function of several variables, including the anticipated market return. The author presents an alternative expression for the latter that produces a simplified equation for riskiness that makes more clear how, all else equal, bonds with short durations will have little risk if changes in yield to maturity and the market portfolio's required return are positively correlated.

The article discusses the relationship between a bond's duration and the yield curve. That a bond's coupon affects its maturity has been acknowledged and commented upon by several authors. Some commentators have expressed the belief that yields are a function of a bond's duration, while others have asserted that the two are completely unrelated. The author presents analysis that shows while duration is a function of the yield curve, the opposite is not true. Given two bonds that always have the same duration and yields to maturity, the entire yield curve from the first two forward rates can be recursively constructed.

Term structure models have often been criticized for failing to explain satisfactorily the yield spread between corporate and Treasury bonds. A potential problem is that the personal tax effect is ignored in these models. In this paper, we employ a structural model to investigate the role of personal taxes on both debt and equity returns in capital structure decisions and assess their impact on corporate bond yield spreads. It is shown that personal taxes affect the firm's optimal capital structure, and the tax premium explains a substantial portion of yield spreads, especially for high-grade bonds. The predictive ability of the model for yield spreads is much improved when personal tax effects are accounted for. In controlling for the liquidity effect, we obtain implied personal income tax rates closely in line with Graham's (1999) estimates. [ABSTRACT FROM AUTHOR]

Abstract: In this paper, we address two main issues: the computation of default probability implicit in emerging markets bond prices and the impact on portfolio risks and returns of expected changes in default probability. Using a reduced-form model, weekly estimates of default probabilities for U.S. Dollar denominated Global bonds of 12 emerging markets are extrapolated for the sample period 1997–2001. The estimation of a logit type econometric model shows that weekly changes of the default probabilities can be explained by means of some capital markets factors. Recursively estimating the logit model using rolling windows of data, out-of-sample forecasts for the dynamics of default probabilities are generated and used to form portfolios of bonds. The practical application provides interesting results, both in terms of testing the ability of a naive trading strategy based on model forecasts to outperform a “customized benchmark”, and in terms of the model ability to actively manage the portfolio risk (evaluated in terms of VaR) with respect to a constant proportion allocation. [Copyright &y& Elsevier]

We investigate whether primary market, original-issue risk premiums on speculative-grade debt are justified solely by expected defaults or whether these risk premiums also include other orthogonal risk components. Studies of secondary-market holding period risk and return have hypothesized that risk premiums on speculative-grade debt may be explained by bond- and equity-related systematic risk and possibly other types of risk. Using an actuarial approach that considers contemporaneous correlation between default frequency and severity and first-order serial correlation, we cannot reject the hypothesis that the entire original-issue risk premium can be explained by expected default losses. This suggests that speculative-grade bond primary markets efficiently price default risk and that other types of risk are priced as coincident as opposed to orthogonal risks. [ABSTRACT FROM AUTHOR]

In the July 1952, issue of the "Accounting Review,"under the title "Some Notes on the Bond Yield Problem," the author discussed the application of a modified or improved Newton's correction formula to the problem of finding the accurate yield on a bond, the improved formula having been briefly set forth in an earlier paper by Hugh E. Stelson,' who had drawn it from one of the mathematical journals. This article includes the continuation of numbers of formulas and equations herein from where they stopped in the preceding article. With serial bonds, the problem of finding the initial approximation to the yield rate is more acute than it is with a single bond. This article also discusses the matter appearing in the thirteen pages of Mr. FitzGerald's article in the "Accounting Review," for January, 1953, on accounting for variations in gross profit.

The article presents discussion regarding research on the empirical methodology of testing bond trading processes and the importance of synchronizing actual transaction prices across corporate bonds with different characteristics. The article mentions research done by Fung and Rudd, Judy E. Maese, Robert J. Rogowski and Eric H. Sorenson. The article states that the effects of the seasoning process and underwriting cost on bond yield behavior may not be as large as previously thought, and the author comments on ideas for further research.

Tests an asset pricing model, where the rate of return on a certain type of bond will be correlated with charges in the marginal utility of the representative investor, using bond market data from the United States between 1973 and 1995. Model performance for the period where the Federal Reserve's focus was on interest rates; Model performance when focus was on the money supply.