| Pricing defaultable bonds is the subject of a vast and rapidly growing literature. Most defaultable bonds, however, have call provisions: more than half of all corporate bonds and over 80% of lower-rated bonds are callable. In this paper, I propose a new technique for valuing bonds that are both defaultable and callable. I demonstrate the implementation of the technique via the simulated methods of moments and empirically fit the model to a large sample of corporate bond prices between 1986 and 1998. The valuation method proposed here models defaults and calls as dual hazards that can be correlated. The technical contribution is to introduce valuation via correlated dual-hazard processes to a literature that has so far priced bonds with only one hazard, i.e., default. The allowable hazard processes are general functions of bond-specific characteristics, exogenous macroeconomic factors or firm characteristics. The moments of this dual-hazard valuation model are not available in closed-form, but I show that implementation is feasible via the simulated method of moments. I fit the model to bond price data. I show that my model fits bond prices well, producing absolute errors around 10 basis points. I use it to recover default hazard rates implicit in bond prices and confirm that previous results based on noncallable bonds alone survive even on a sample of callable bonds. Additionally, I recover the first estimates call hazard rates and their cross-sectional properties. I show that the call hazards are consistent with actual calls made by firms. I also demonstrate that the techniques proposed here can be readily used to incorporate other features in bond indentures such as conversion, putability, indexed calls, and floating coupons. |
