THE JOURNAL OF DERIVATIVES 25 FALL 2015 Interest Rates and Credit Spread Dynamics ROBERT NEAL, DOUGLAS ROLPH, BRICE DUPOYET , AND XIAOQUAN J IANG ROBERT NEAL is an associate professor of finance at Indiana Univer- sity in Indianapolis, IN. skyking@indiana.edu DOUGLAS ROLPH is a senior lecturer at Nan- yang Business School at Nanyang Technological University in Singapore. drolph@ntu.edu.sg BRICE DUPOYET is an associate professor of finance at the College of Business at Florida Inter- national University in Miami, FL. dupoyetb@fiu.edu XIAOQUAN JIANG is an associate professor of finance and Knight Ridder Research Fellow at the College of Business at Florida International University in Miami, FL. jiangx@fiu.edu This article revisits the relationship between call- able credit spreads and interest rates. The authors use cointegration to model the time series of corpo- rate and government bond rates and draw infer- ence about how credit spreads evolve after a shock to government rates using a bootstrapped standard error methodology. They find little evidence that unexpected changes to government rates lead to a significant change in future credit spreads. These results hold for both large positive and negative shocks, as well as after conditioning on the pre- vailing interest rate environment. C redit spreads are negatively cor- related with interest rates through the impact of changes in interest rates on the credit conditions of corporations. Most theoretical studies con- sider these correlations in the context of risk- neutral valuation models of corporate debt and focus on the effect that interest rates have on the growth in firm value. These models specify how firm value evolves over time and assume that default is triggered when the firm value falls below some default threshold. The default threshold is a function of the amount of debt outstanding. 1 Because the (risk-neutral) growth of the firm increases with the instantaneous risk-free rate, the likelihood that the firm value falls below the default threshold decreases and the credit risk premium declines. This effect induces a negative correlation between credit spreads and interest rates. A number of empirical studies pro- vide evidence of a strong negative rela- tionship between changes in credit spreads and interest rates. The negative correlation between interest rates and credit spreads per- sists after controlling for firm- and market- level determinants of default risk (Longstaff and Schwartz [1995], Collin-Dufresne et al. [2001], Avramov et al. [2007], Campbell and Taksler [2003]). Although the general con- sensus in the literature points to a negative link between credit spreads and government rates, the call feature of corporate debt has the potential to induce a source of common variation in credit spreads and interest rates that is unrelated to default risk (Jacoby et al. [2009]). For callable bonds, higher interest rates imply a lower chance that the issuer will exercise the call option. Thus, bondholders will accept a lower yield for these call provi- sions, which will result in an overall decrease in the bond yield spread. Although the neg- ative relationship between credit spreads and interest rates weakens for non-callable bonds, there remains a statistically significant decrease in credit spreads for several months following a positive shock to short-term gov- ernment rates (Duffee [1998]). A common approach in the literature is to regress contemporaneous credit spreads or changes in credit spreads on contemporaneous JOD-NEAL.indd 25 JOD-NEAL.indd 25 8/18/15 4:56:09 PM 8/18/15 4:56:09 PM Author Draft for Review Only