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Many theoretical bond pricing models predict that the credit yield curve facing risky bond issuers is downward-sloping. Previous empirical research (Sarig and Warga (1989), Fons (1994)) supports these models. Our study examines sets of bonds issued by the same firm with equal priority in the liability structure, but with different maturities, thus holding credit quality constant. We find, counter to prior research, that risky bonds typically have upward-sloping credit yield curves. Moreover, when we combine our matched sets of bonds (no longer controlling credit quality), the estimated slope is negative, indicating a sample selection bias problem associated with maturity. USING OPTION ANALYSIS, Merton (1974) shows that corporate bond spreads can either increase or decrease with maturity, depending on the risk of the firm: High-grade corporate issuers face upward-sloping credit yield curves and speculative-grade firms' credit yield curves are downward-sloping or humpshaped (i.e., mostly downward-sloping). More recent theoretical research (e.g., Jarrow, Lando, and Turnbull (1997) and Longstaff and Schwartz (1995)) also predicts similar credit yield curves. Sarig and Warga (1989) and Fons (1994) find empirical evidence supporting these models. Although market practitioners tend to agree with academics that the risk term structure is upward-sloping for high-quality credits, practitioners typically do not view the slope of the curve facing high-yield issuers as negative.1 Our investigation provides some empirical support for the practitioners' view of the world: Contrary to many bond pricing models' predictions, the credit yield curve for most speculative-grade firms appears upward-sloping. |
