Financial markets offer a standard real risk-free rate of interest, one equivalent to the rate the Treasury extends on its inflation-protected securities. Corporate bonds offer higher rates. The increased returns compensate investors for risks and costs associated with the investment. The default risk premium, one component of the increased returns, takes into account the risk that the corporation will declare bankruptcy before the bond matures. Corporations, unlike the U.S. government, represent a significant risk of default, and the default risk premium serves as a balance against the potential for loss.
Subtract the Treasury rate on inflation-protected securities from the corporate bond's annual percentage yield. For example, if the Treasury offers a 0.3 percent rate on 10-year securities and the bond offers a return of 7.6 percent, subtract 0.3 from 7.6 to get 7.3 percent.
Subtract from this difference the predicted inflation rate over the bond's life, which forms the bond's inflation premium. For example, if this annual rate is 4.2 percent, subtract 4.2 from 7.3 to get 3.1 percent.
Subtract from this difference the bond's listed liquidity premium. The liquidity premium compensates investors for the liquidity they lose in converting their cash to the fixed bond. For example, if the bond offers a liquidity premium of 2.0 percent, subtract 2.0 from 3.1 to get 1.1 percent. This value is the corporate bond's default risk premium.
- Introduction to Finance; Ronald W. Melicher et. al.
- Intermediate Financial Management; Eugene F. Brigham et. al.
- Fitch Ratings. "Fitch Ratings: Credit Ratings & Analysis for Financial Markets." Accessed May 3, 2020.
- Treasurers.org. "Corporate credit ratings: a quick guide," Page 1. Accessed May 3, 2020.
Ryan Menezes is a professional writer and blogger. He has a Bachelor of Science in journalism from Boston University and has written for the American Civil Liberties Union, the marketing firm InSegment and the project management service Assembla. He is also a member of Mensa and the American Parliamentary Debate Association.