Coupon Effects on Corporate Bonds: Pricing, Empirical Duration, and Spread Convexity

The traditional approach for pricing corporate bonds based on discounting their promised cash flows by a combination of rates and spreads implies that a bond’s coupon level by itself should not have any effect once all its cash flows have been properly discounted. In this article, the authors explore several possible effects of coupon level on the pricing and performance of corporate bonds. First, is there a relationship between the coupon (price) of a bond and its spread relative to other bonds of the same issuer? Second, does coupon level have an effect on the empirical duration of a bond—that is, on its sensitivity to changes in Treasury yields? Finally, do these effects present an opportunity for portfolio outperformance? The authors find that discount bonds tend to have lower spreads than premiums, reflecting the fact that they are better shielded from default risk by recovery values. This phenomenon has an asymmetric effect on empirical duration. Corporate bonds trading at a discount have a reduced sensitivity to rising rates and an increased sensitivity to falling rates; premiums exhibit the opposite effect. This “spread convexity” effect leads to long-term outperformance of discounts over premiums. Over the last 20 years, a long/short strategy using discounts and premiums generated an information ratio greater than 1, showing strong performance especially in periods when default risk was perceived to be high.