Corporate bond yield approximation using piece wise cubic spline and residuals estimation with liquidity factors

Abstract

Corporate bond yields are not easy to approximate on account of their limited trading frequency and irregularity in issuance. The corporate bond market in India demonstrates poor investor participation. The purpose of this paper is to present an account of piece wise cubic spline methodology of yield estimation that can be feasibly implemented by practitioners. This paper attempts to approximate the corporate bond yield using residual maturity for listed and traded bonds using traded data from the period January 2001 to October 2014. We use a two stage process, where in the first stage, we model the yield behavior of corporate bonds against their residual maturity nodes of 3 years, 5 years and 20 years, respectively. In the second stage, we identify the significant factors of bond liquidity that impacts the cubic spline residual to improve accuracy in estimation. The first step of piece wise cubic spline estimates the 3 node parameters to predict the logarithmic yield to maturities against their remaining maturity in years. The second step intends to analyze the prediction errors and provides for correction in accuracy incorporating factors of bond liquidity such as issuer, issue and liquidity factors, respectively. The dual approach explains the variation in yields and could be used for identifying quality papers and the reasons for lower investor participation in bond markets and for arriving at term structure in related markets. This does not include pure central govt. loans, state loans, treasury bills, dated securities, bond of departmental undertaking or india development bonds.