Risk Premium of Corporate Bonds

• Credit Risk Premium is similar to equity risk premium
• Defined as the non-default component of corporate bond spreads
• To ensure proper comparison, credit risk premium should be adjusted for the difference between expected returns on T-Bonds and T-Bills
• Non-monotonically related credit ratings

• Although yield spreads of risky bonds over treasury are observable, it is hard to tell how much is the compensation for the expected default and how is due to risk aversion and other factors

• 2 classes of pricing models to estimate default rates requiring an assumption that credit risk premium is zero
• Reduced Form Models
• Mathematically, complex structural approach based on option pricing

• Both models reach the same conclusion that spreads on corporate bonds are much wider than what would be required to compensate for credit losses alone

• This difference is assumed to be credit risk premium
• Illiquidity is often cited as a reason for positive non-default components of spreads
• Estimating required compensation for illiquidity is not easy
• Liquidity premium and credit risk premium are closely related

• Credit risk premium rises as ratings deteriorate

• Each type of model has its weakness
• Structural model rely too much on equity market
• In the transition model, variance is high and default rates fluctuate from long term average

• BB rated bonds tend to outperform other credit tiers on a total return basis
• Implies BB bonds have had the highest credit risk premium
• From highest rated until BB more risky bonds outperform less risky ones on absolute basis
• After BB the relationship is reversed
• CCC rated bonds have had negative returns over treasury bonds. However, during recovery following a recession they perform quite strongly

• Active investors can add value to their portfolio by tactically adding B and CCC rated bonds during market upswings and removing during downturn. Passive investors looking for highest returns should invest in BB as they have the best absolute performance

• In risk adjusted returns (Sharpe Ratio) AAA, AA & A rated bonds are better

• Given a relatively short history of B and CCC bonds, investors have underestimated their propensity to default and thus the realized risk premiums for these have been lower
• There have been only 2 recessions for the B rated (1999 & 2001) and only 1 for CCC (2001)

• 3 reasons for why expected returns in BB and not B CCC have been higher
• Lack of natural buyers for BB and fallen angel effect where investment grade bonds enter at attractive prices
• High yield investors have overestimated their security selection skills. Search for yield leads them to B & CCC instead of BB
• Investors may have bought lowest tiers anticipating a supportive environment