1. Suppose 10-year T-bonds have a yield of 5.30% and 10-year
corporate bonds yield 8.90%. Also,
corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium
for T-bonds, and the maturity risk premium on both Treasury and corporate
10-year bonds is 1.15%. What is the
default risk premium on corporate bonds?
Thank you for the opportunity to help you with your question!
A T-bond yield can be seperated into the following components: r*+IP+MRP
r* = real rate of interest
IP= inflation premium
MRP=Maturity risk premium
Whereas, a corporate bond yield can be separated into: r*+IP+MRP+LRP+DRP
The only difference being the addition of a liquidity risk premium and a default risk premium.
Unlike a corporate bond, a treasury bond is backed by the full faith and credit of the United States government. This makes the default risk premium of holding a treasury bond equal to zero. Furthermore, treasury bonds are the most liquid securities in the bond market. This makes the liquidity risk premium for treasury bonds equal to zero.
Now that we have covered the conceptual aspect of yields, we are able to solve the problem:
From the treasury yield we know r*+IP+MRP=5.30%. We can now plug this information into the equation for corporate bond yield.
As we know that LRP(default risk premium on corporate bonds) is equal to .25%, so, just plug it in:
Now we wiIl isolate DRP by moving terms to the other side
DRP (default risk premium on corporate bonds )= 3.35% or 335 basis points.
Please let me know if you need any clarification. I'm always happy to answer your questions.
Jul 12th, 2015
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