What is Default Risk Premium?

Investors are considered “risk averse,” meaning they expect compensation in the form of higher returns for taking on more risk in the form of greater uncertainty about return fluctuations or outcomes.

This is the cornerstone of finance, known as the risk-return principle or the principle of “higher returns are expected for taking on more risk.” Default risk is the risk that a borrower will not repay the interest and/or principal on a loan or other debt instrument according to the agreed terms of the contract.

The result may be a lower than expected interest rate or yield, or even a complete loss of the amount originally borrowed. The default risk premium is an additional market interest rate component that provides higher expected compensation for assuming the risk of default. The default risk premium increases as the probability of default increases.

To examine default risk premiums for debt securities, it is necessary to hold some of the other components of market interest rates constant. We can develop a procedure for measuring that portion of a market interest rate (r) attributable to default risk. Recall that the market interest rate is a function of a real interest rate, an inflation premium, a default risk premium, a maturity risk premium, and a liquidity risk premium.

First, we constrain our analysis to the long-term capital markets by considering only long-term Treasury bonds and long-term corporate bonds. By focusing on long-term securities, the maturity risk will be the same for all the bonds and can be set at zero for analysis purposes. 

We have also said that the liquidity premium is zero for Treasury securities, because they can be readily sold without requiring a substantial price discount. Corporate securities are less liquid than Treasury securities. 

However, we can minimize any possible liquidity premiums by considering the bonds of large corporations. This also allows us to set the liquidity premium at zero for analysis purposes.

For the following example, assume that the real rate is 1 percent, inflation is expected to average 2 percent, the market interest rate is 3 percent for long-term Treasury bonds, and high-quality corporate bonds have a 5 percent market interest rate. Using equation, we have the following:

r = RR + IP + DRP + MRP + LP 

5% = 1% + 2% + DRP + 0% + 0%

DRP = 5% – 1% – 2% – 0% – 0% = 2%

Since the 3 percent Treasury bond represents the risk-free rate of interest, subtracting the 1 percent real rate results in a long-term average annual inflation premium of 2 percent. Another way of looking at the default risk premium (assuming zero maturity risk and liquidity premiums) is that it is the difference between the interest rates on the risky (corporate) and risk-free (Treasury) securities. In our example, we have,

DRP = 5% – 3% = 2%

Thus, investors require a 2 percent premium to hold or invest in the corporate bond instead of the Treasury bond.

Another corporate bond with a higher default risk may carry an interest rate of, say, 7 percent. If the other assumptions used above are retained, the DRP would be,

7% = 1% + 2% + DRP + 0% + 0% DRP = 7% – 1% – 2% – 0% – 0% = 4%

Alternatively, we could find DRP as follows:

DRP = 7% – 3% = 4%

Thus, to get investors to invest in these riskier corporate bonds, a default risk premium of four percentage points must be offered above the interest rate, or yield, on Treasury bonds.

One way potential default risk is measured is through bond ratings. The highest rating assigned by Moody’s, a major bond-rating agency, is Aaa and indicates the lowest likelihood of default. Investors in these bonds require a small default risk premium over Treasury bonds. 

Baa-rated bonds have higher default risks but still are considered to be of reasonably high quality. Investment-grade bonds have ratings of Baa or higher and meet financial institutions (banks, pension funds, insurance companies, etc.) investment standards.

In March 1980, the default risk premium on corporate Aaa-rated bonds over 20-year Treasuries was 0.5 percentage point (i.e., 13.0 – 12.5 percent). The default risk premium on Aaa-rated corporate bonds had increased to an unusually high 1.7 percentage points in November 2001, reflecting an economic downturn and concerns about terrorism in the United States. 

The October 2006 risk premium for Aaa-rated bonds remained low at a 0.6 percentage point differential over 20-year Treasury bonds. By October 2008, when the United States was in the midst of the 2007–08 financial crisis and the 2008–09 recession, the risk premium for Aaa-rated bonds had increased to 1.0 percentage point. 

The Aaa-rated corporate bond risk premium was 1.13 percent in December 2012 and increased to 1.36 percent in December 2015.

The default risk premiums on Baa corporate bonds are generally better indicators of investor pessimism or optimism about economic expectations than are those on Aaa-rated bonds. More firms fail or suffer financial distress during periods of recession than during periods of economic expansion. 

Thus, investors tend to require higher premiums to compensate for default risk when the economy is in a recession or is expected to enter one. Notice in Table 8.4 that the risk premium on Baa-rated bonds was two percentage points in March 1980 (14.5 – 12.5 percent). 

The default risk premium on Baa-rated bonds was 2.5 percentage points in November 2001 and reflected concerns about the slowing of economic activity in the United States and continued uncertainty after the terrorist attack on September 11, 2001. 

As of October 2006, the risk premium on Baa-rated corporate debt was 1.5 percentage points over the interest rate on 20-year Treasury bonds.

The Baa-rated bond risk premium increased to 2.1 percentage points by October 2008, due to the financial difficulties in the United States. Baa-rated corporate bonds relative to 20-year Treasury bonds exhibited a 2.09 percent risk premium in December 2012 and a 2.85 percent premium in December 2015. 

The relatively high default risk premium at the end of 2015 reflects concern about possibly slower economic growth. Being risk-averse, bond investors will require higher expected additional compensation when they believe the probability of default increases.

Sometimes corporations issue bonds with ratings lower than Baa. These are called high-yield or junk bonds because they have a substantial probability of default. While many institutional investors are restricted to investing in only investment-grade (Baa-rated or higher) corporate debt, others are permitted to invest in high-yield, high-risk corporate debt.

Leave a Comment