Corporate yield spreads and real interest rates Jonathan A. Batten a,1 , Gady Jacoby b , Rose C. Liao c a Department of Finance, Monash University, Caulfield Campus, PO Box 197, Caulfield East, Victoria 3145, Australia b Department of Accounting and Finance, I.H. Asper School of Business, University of Manitoba, Winnipeg, MB R3T 5V4, Canada c Department of Finance Economics, Rutgers Business School, 111 Washington Street Newark, NJ 07102, United States abstract article info Article history: Received 6 February 2014 Received in revised form 26 May 2014 Accepted 30 May 2014 Available online 5 June 2014 JEL classification: C22 C13 C53 G12 Keywords: Credit spreads Corporate bonds Real interest rates Reduced-form models Structural models The effect of inflation on the credit spreads of corporate bonds is investigated utilising real instead of nominal interest rates in extensions of the models proposed by Longstaff and Schwartz (1995) and Collin-Dufresne et al. (2001). Inflation is a critical, non-default, component incorporated in nominal bond yields, whose effect has not been considered by existing credit spread theory. In this sense the only true test of models of credit spread pricing must utilise real rates. To illustrate these requirements the Canadian bond data of Jacoby, Liao, and Batten (2009) is utilised. This Canadian data accommodates callability and the tax effects otherwise present in U.S. bond markets. The relation with historical default rates of both U.S. and Canadian bonds is also investigated since this approach is clean of both callability and tax effects. Overall, the analysis provides additional insights into the theoretical drivers of credit spreads as well as helping to explain observed corporate bond yield behaviour in financial markets. © 2014 Published by Elsevier Inc. 1. Introduction Much attention in recent years has been directed towards the catastrophic impact information opacity and design complexity present in credit derivatives has had on the valuations of financial institutions and subsequently on the real economy. This was especially the case during the 2007–2009 Global Financial Crisis (Avino, Lazar, & Varotto, 2013; Dabrowski, 2010; Domler, 2013; Gorton, 2009; van Rixtel & Upper, 2012). As noted by Longstaff, Mithal, and Neis (2005), many simple questions concerning the underlying pricing and trading of credit based derivatives and securities in corporate bond markets remain unanswered. For exam- ple, how do financial markets price corporate debt and what proportion of the bond yield above the equivalent maturity risk-free bond – termed the credit spread – is due to default risk? What effect do non-default com- ponents, such as inflation, have on the pricing of credit spreads? Inflation is a critical non-default component incorporated in corporate bond yields that has not been previously recognised in theoretical models of corporate credit spread behaviour. In this sense the only true test of the various theoretical models should utilise real rates not nominal rates. Motivated by these insights, the objective of this study is to investi- gate this last issue by identifying and then separating the inflation component of corporate bond yields prior to the investigation and modelling of credit spreads. We begin by updating and reviewing the existing literature on credit spread modelling, thereby provid- ing clear insights into the theoretical drivers of credit spreads. Our contribution adds to the earlier work by Jacoby et al. (2009) by better explaining the observed corporate bond yield behaviour in financial markets, which has been shown by many other authors to include factors other than compensation for credit and liquidity risk (e.g. Breitenfellner & Wagner, 2012; Collin-Dufresne, Goldstein, & Helwege, 2010; Eom, Helwege, & Huang, 2004; Loncarski & Szilagyi, 2012; Ronen & Zhou, 2013). In a key empirical paper, Longstaff and Schwartz (1995) extend the Merton (1974) model of corporate default to allow the testing of credit spreads using Moody's indexed U.S. bond yields. One of the more notable predictions of the Merton model is that the change in the credit spread is negatively correlated to the return on risky assets and changes in default-free interest rates. While the Longstaff and Schwartz (1995) results are consistent with this theoretical view, Duffee (1998) argued International Review of Financial Analysis 34 (2014) 89–100 E-mail addresses: jonathan.batten@monash.edu (J.A. Batten), gady.jacoby@umanitoba.ca (G. Jacoby), rliao@andromeda.rutgers.edu (R.C. Liao). 1 Tel.: +61 3 9555 3160. http://dx.doi.org/10.1016/j.irfa.2014.05.009 1057-5219/© 2014 Published by Elsevier Inc. Contents lists available at ScienceDirect International Review of Financial Analysis