The Credit Risk Premium and Return Predictability in High Yield Bonds (2024)

FAQs

What is the credit risk spread for high-yield bonds? ›

A high-yield bond spread, also known as a credit spread, is the difference in the yield on high-yield bonds and a benchmark bond measure, such as investment-grade or Treasury bonds. High-yield bonds offer higher yields due to default risk. The higher the default risk the higher the interest paid on these bonds.

The credit risk premium is the expected excess return investors earn from bearing default risk on high yield bonds.

All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.

High yield bonds – defined as corporate bonds rated below BBB− or Baa3 by established credit rating agencies – can play an important role in many portfolios.

Higher yields mean that bond investors are owed larger interest payments, but may also be a sign of greater risk. The riskier a borrower is, the more yield investors demand. Higher yields are often common with a longer maturity bond.

Credit risk.

If investors think that the issuer of a bond is less likely to pay the interest or amount borrowed in the bond at the agreed time, then they will demand a higher yield to own the bond.

Calculating the Risk Premium

Now that you have determined the estimated return on an investment and the risk-free rate, you can calculate the risk premium of an investment. The formula for the calculation is this: Risk Premium = Estimated Return on Investment - Risk-free Rate.

The bond risk premium is a critical concept in the world of fixed-income investments. It represents the additional yield investors demand to compensate for the risks associated with holding a bond compared to a risk-free security, such as a U.S. Treasury bond.

US Corporate BBB Bond Risk Premium is at a current level of 1.32, up from 1.30 the previous market day and down from 2.05 one year ago. This is a change of 1.54% from the previous market day and -35.61% from one year ago.

After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.

Which bond has the highest credit risk? ›

Bonds that have the greatest credit risk are junk bonds. Junk bonds refer to very low-rated, sometimes unrated, bonds issued by a private corporation or a country. While many factors are considered for rating bonds as junk, the most common one is its issuer's high likelihood of default.

Junk bonds are debt securities rated poorly by credit agencies, making them higher risk (and higher yielding) than investment grade debt. A fixed-income security is an investment that provides a steady interest income stream for a certain period.

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

High-yield bonds generally face less interest-rate risk than their investment-grade counterparts—meaning that, all else equal, they suffer smaller price losses when interest rates rise. (Investors can compare interest-rate risk by looking at a bond or bond fund's duration.) But credit risk is higher.

Bond credit spreads are often used to gauge the market's perception of the creditworthiness of a particular issuer or sector. A wider credit spread means that investors perceive a higher risk of default and require a higher yield to compensate for that risk.

The difference between a bond's yield compared to that of a relatively risk-free U.S. Treasury bond of the same maturity is known as a credit spread. Determining a bond's credit spread is a common way to judge how much of a premium you could potentially collect for taking on more risk.

While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry a number of risks, like default risk, higher volatility, interest rate risk, and liquidity risk.

US High Yield B Option-Adjusted Spread is at 2.88%, compared to 2.92% the previous market day and 4.61% last year. This is lower than the long term average of 5.34%.