How to Calculate a Default Risk Premium

How to Calculate a Default Risk Premium
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Though bonds should pay their principal and dividends when they mature, corporations that issue them might first declare bankruptcy, depriving investors of returns. This risk discourages those who would otherwise invest in the bonds. To compensate investors for the chance of defaulting, bond issuers include a default risk premium with the bond's yield. This addition to the return rate offers the investor higher dividends, raising the bond's overall expected value even if the issuer may default.

Determine the real risk-free rate of interest. One source of this information is the rate that the U.S. Treasury applies to Treasury Inflation-Protected Securities (TIPS). For example, suppose that you are calculating the default risk premium on a 10-year bond and the real risk-free rate for 10-year securities is 0.4 percent.

Add the bond's inflation premium, which is the predicted annual inflation rate during the life of the bond. For example, if this rate is 4 percent, add 4 to 0.4, giving 4.4 percent.

Add the bond's stated liquidity premium. The liquidity premium compensates you for your inability to convert the bond's principal to cash before maturity. For example, if the bond offers a liquidity premium of 1.2 percent, add 1.2 to 4.4, giving 5.6 percent.

Subtract this value from the bond's annual percentage yield. For example, if the bond offers an annual return of 7.1 percent, subtract 5.6 from 7.1, giving 1.5 percent. This is the bond's default risk premium.