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Suppose 10-year U.S. Treasury bonds (T-bonds) have a yield of 5.30% and 10-year corporate bonds yield...

Suppose 10-year U.S. Treasury bonds (T-bonds) have a yield of 5.30% and 10-year corporate bonds yield 6.65%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for Treasury bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

I don’t have a financial calculator. Please show how to solve without a financial calculator.

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Answer #1

Total yield is a sum of risk free rate (including inflation premium) + default risk premium + liquidity premium + maturity risk premium

For t-bonds total yield = risk free rate + default risk premium + liquidity premium + maturity risk premium

5.3%= risk free rate+ 0 (considered safest so no default premium) + 0 (considered liquid so no liquidity premium) + 1.15%

therefore risk free rate = 5.3%-1.15%=4.15%

For corporate bond total yield = risk free rate + default risk premium + liquidity premium + maturity risk premium

6.65% = 4.15%+default risk premium+ 0.25% + 1.15%

therefore default risk premium = 6.65%-0.25%-1.15%=1.1%

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