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Question 7 If 30-year T-bonds have a yield of 7.2%, 30-year corporate bonds yield 9.9%, the...

Question 7 If 30-year T-bonds have a yield of 7.2%, 30-year corporate bonds yield 9.9%, the maturity risk premium on all 30-year bonds is 1.6%, and corporate bonds have a 0.6% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?

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Answer #1

The formula for the quoted interest rate for Corporate Bond is:

r= r* + IP + DRP + LP + MRP

where r= the nominal, quoted rate of interest on a given security

r*= risk free rate IP= inflation premium DRP= default risk premium LP= liquidity premium MRP= maturity risk premium

The formula for the quoted interest rate for Treasury Bond is:

r = r* + IP + MRP

30-year T-bonds Yield = 7.20% 30-year Corporate bonds = 9.9% MRP on all 30-year bonds = 1.6%   

Liquidity premium of corporate bonds = 0.6%

Inflation premium is also assumed to be same on all 30-year bonds

we know that:

Corporate Bond Yield Spread = 10-year Corporate Bond Yield - 10-year Treasury Bond Yield

9.90% - 7.20% = (r* + IP + DRP + LP + MRP) -  (r* + IP + MRP)

2.70% = DRP + LP

2.70% = DRP + 0.6%

DRP =  2.70% - 0.60% = 2.10%

Default risk premium on the corporate bond is 2.10%

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