CREDIT RISK PREMIUMS
James A. Gentry
Professor Emeritus of Finance and University Distinguished Teacher
Scholar
University of Illinois
j-gentry@illinois.edu
Frank K. Reilly
Bernard J. Hank Professor of Finance
University of Notre Dame
Reilly.1@nd.edu
David J. Wright
Professor of Finance
University of Wisconsin-Parkside
Wright@UWP.edu
February 19, 2009
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CREDIT RISK PREMIUMS
Bond investors expect to receive a premium for taking credit risk when investing
in investment grade or non-investment grade bonds. This risk premium is referred to as
either a credit risk premium (CRP) or a credit risk spread (CRS). Changes in the outlook
for a company can result in changes the CRP. For example, an increase in the CRP of a
company sends a negative market signal to investors, corporate management, bond
traders, bank loan committees and other interested stakeholders. Required credit risk
premiums are to the bond investors what required equity risk premiums are to common
stock investors.
Credit risk premiums represent the spread that exists between the yield-tomaturity [YTM] on corporate bonds and the YTM on 10 or 20 year U. S. Treasury (UST)
bonds. For example, the spread between YTM on a BBB rated corporate bond and the
YTM on risk-free long-term UST bonds reflects the credit risk premium (CRP) or credit
risk spread (SRS) received by BBB corporate bond investors. In equation form,
CRP or CRS = KBBB – KRF
KBBB = current market rate of return (YTM) on an S&P rated bond.
KRF = YTM on a risk free long-term UST bond
We shall use Figure A to develop the components that underlie the theoretical
structure of rates of return on UST bonds and corporate bonds. In creating this example
we shall start by assuming the pure rate of return is 3 percent. The pure rate of return is
assumed to be the return generated on any asset regardless of s firm’s capital structure, e.
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g., its debt ratio, or the credit risk of the firm that is reflected in its bond rating. The pure
rate is the base rate or the minimum return expected on an asset.
What would be the next theoretical concept used in explaining the structure of
interest rates of return? The next level reflects the rate of inflation. Let’s assume the rate
of inflation is 4 percent. Will inflation be constant across all capital structures, regardless
of the firm’s bond rating? Yes, inflation is assumed to be constant in the economy across
all capital structures and/or bond ratings. Thus, the risk-free rate of return on a 20 year
UST bond (KRF) is 7 percent, i.e., KRF = 0.03 + 0.04.
The final component in the structure of interest rates reflects the creditworthiness
of a company, referred to as firm’s credit risk exposure. What is the creditworthiness of
the UST bonds? The assumption is that the U. S. Treasury bonds are risk-free, and
investors do not expect to receive a credit risk premium on UST securities.
How does the bond market determine the credit risk premium on a corporate
bond? Determining the creditworthiness of a company is a complex process. Figure A
simplifies this process by assuming a firm’s creditworthiness is reflected in its debt ratio.
For example, if a company has a low debt ratio, say a D/D+E ratio of 20 percent, it would
more-than-likely receive a Moody’s bond rating of Aa. Under these conditions bond
investors would expect to receive a low credit risk premium, for example 50 basis points
greater-than the risk free rate of 7 percent or return of 7.50 percent, KdAa = 0.07 + 0.005.
If a company has a debt ratio of 30 percent, it is apparent that its credit risk is
greater than the preceding example. Under these conditions bond investors would expect
a higher credit risk premium, for example 125 basis points greater than the risk free rate,
or a return of 8.25 percent. If a third company has a debt ratio of 50 percent, the credit
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risk premium is going to be significantly higher, say 300 basis points or 10 percent.
Thus, the higher the perceived credit risk, the lower a firm’s creditworthiness and, in
turn, the greater the credit risk premium.
Size and Stability of Credit Risk Premiums
In a recent working paper “The Historic Changes In the High Yield Bond
Market”, Reilly, Wright and Gentry (RWG) [2009] reached several significant
conclusions. First, they observed the overall high yield (HY) bond market has
experienced strong cyclical growth, over 13 percent a year for 20 years, there has been a
significant change in its composition with the strongest growth recorded in the BB-rated
segment1. Second, RWG noted “an analysis of return volatility indicated tat during
periods of economic stability HY bonds experienced volatility very similar to investmentgrade bonds, but HY bond volatility become about three times greater during periods of
economic uncertainty”. 2
The following provides a brief analysis of the size and stability of CRS for the 20
year period, 1989-2008, Exhibits 1-4 show the CRS for AAA, AA, A and BBB rated
bonds, respectively. The CRS for the HY bonds rated BB, B and CCC are presented in
Exhibits 5-7, respectively. The size and stability of the CRS are shown in Exhibit 8 for
all seven bond ratings in five sample time periods. The size of the CRS are measured in
basis points (bp) and the stability is reflected in the volatility of the CRS.
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1. Reilly, Wright and Gentry, 2009, Historic Changes in the High Yield Bond
Market, Working Paper, p. 2.
2. Ibid.
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January 1989 reflects the end of a relatively stable period of business conditions
and the beginning of a period unstable business conditions. Exhibit 8 shows the CRS
were relatively low for the investment grade bonds-50 to 125 bp, but high for the HY
bonds, 270bp to 700bp, thereby suggesting the beginning of a period of economic
uncertainty.
In January 1993, Exhibit 8 reflects the ending of a period of economic
uncertainty. The CRS ranged from 150 to 200 basis points for the investment grade
bonds, and these CRS are substantively higher than the basis points in January 1989.
However, The CRS for the HY bonds were only modestly higher than the CRS for
investment grade bonds on January 1993, 240 bp to310 bp.
The pattern of the CRS on January 1998 portray a CRS pattern that is
comparable to the January 1989 period, as shown in Exhibit 8. The CRS for the
investment grade bonds were relatively small, 75 bp to 110 bp, and the HY CRS ranged
from 280 bp to 800 bp.
The CRSs for the January 2004 also looks like the end of an unstable period.
The CRS for the investment grade bonds range from 40 to 180 bp, and the AA rated
bonds had a lower CRS than the AAA rated bonds. The HY bond CRSs ranged from 200
bp to 500 bp
In December 2008 the CRS are at an all time high for both the investment grade
bonds and the HY (junk) bonds. If the risk-free interest rate was 2 percent the BBB rated
bonds had a bond yield of 9.2 percent and the CCC rated bonds reflected a bond yield of
29 percent. A phenomenal set of CRS appear in Exhibit 8. The size of the CRS indicate
periods of great uncertainty in future economic conditions.