The Determination of Yield Differentials Between Debt Instruments of the Same Maturity

DEBT INSTRUMENTS of comparable risk level and maturity and with similar provisions do not necessarily have the same market yield. Moreover, the yield diSerentials between diSerent instruments of comparable risk level and maturity vary considerably over time. In June, 1964, for example, the yield differential between AA-rated utility bonds and government bonds of the same maturity was 30 basis points (30/100 of one per cent), whereas in June, 1969 the diSerential was 147 basis points.l The yield spread between utility and industrial bonds of comparable quality and with similar pro^>isions (call features, coupon size, etc.) has also varied over time, the differential being positive during certain periods and negative during others. The purpose of this paper is to examine the yield diSerentials among three types of debt instruments: long-term United States government bonds, high quality utility bonds, and high quality industrial bonds. These three categories of bonds are of roughly the same maturity and risk level. The default risk for the high quality utility and industrial bonds considered in this study is essential]y negligible, as is, of course, the default risk for U.S. government bonds. In Section II the question of why the three types of bonds are not perfect substitutes for one another is examined. A simple model determining the yield diSerentials is then developed in Section III, and the results of estimating the model are presented in Section IV.