The Risk Premium of Corporate Bonds

Abstract

The expected risk premium of corporate bonds, defined as the non-default component of corporate bond spreads, is generally related non-monotonically to credit ratings. Over the course of a complete credit cycle, the risk premium is positive and higher than actual spreads for investment-grade bonds; it rises in absolute terms as ratings deteriorate, to reach a peak in the BB sector, and then starts falling and becomes negative for CCC-rated bonds. Explanations for such a peculiar shape of the expected risk premium curve range from inefficiencies due to market segmentation to the tendency of high-yield portfolio managers to overestimate their security selection skills. For investors concerned with generating the best risk-adjusted returns, the contour of the risk premium curve promotes investment-grade bonds, but for investors willing to tolerate more volatility to achieve higher absolute returns, crossing into speculative-grade territory to gain a BB exposure is the preferred structural strategy. Finally, corporate bonds rated B and below should be considered only by investors with superior (and rare) ability either to select outperforming individual securities or to time the market accurately.