All investments have some level of risk, and bonds are no exception. Some bonds have virtually no chance of default, such as U.S. Treasuries, while others have a significant default risk.
Companies issue bonds in order to raise capital and meet other financial obligations, and if all bond interest rates were equal, investors would only buy bonds of the least-risky companies and government agencies. So, in order to entice investors to buy their bonds, companies with less-than-perfect credit ratings are forced to pay higher interest rates than companies the market perceives as "safe." This is known as a default risk premium.
What makes up a bond's interest rate?Many investors don't realize it, but interest rates paid by bonds are actually the sum of several individual components.
- Risk-free interest rate:This is the interest rate an investor could receive from an investment with no risk whatsoever. I mentioned earlier that the U.S. Treasury issues bonds that are considered to be risk-free. Of course, there is some risk associated with any bond, but the three-month Treasury is a widely used benchmark for the risk-free rate.
- Inflation premium:The expected inflation rate, since investors expect their bonds to keep up with inflation. This compensates investors for their money's potentially reduced purchasing power when the bond matures.
- Liquidity premium:Some bonds offer this, and it is meant to offset the inconvenience of not being able to easily sell the bond. Stocks are said to have a "liquid" market, since you can simply hit a button and sell a stock at any given time for market value. The same cannot be said for many bonds.
- Maturity premium:Longer-dated bonds tend to pay higher rates than those with shorter maturities. For example, if a 1-year CD pays 1.5% and a 2-year CD pays 2%, the 0.5% difference is a maturity premium.
- Default risk premium:The component of the interest rate that compensates investors for the higher credit risk from the issuing company. A default occurs when a company misses an interest payment to its bondholders, so a default risk premium is intended to offset this risk with higher interest payments.
Calculating the default risk premiumBasically, to calculate a bond's default risk premium, you need to take its total annual percentage yield (APY), and subtract all of the other interest rate components.
For example, let's say that Company X is issuing bonds with a 7% APY. If the risk-free rate is 0.5%, inflation is estimated to be 2.5%, and the bond's liquidity and maturity premiums are both 1%, adding all of these together produces a total of 5%. Subtracting this from the bond's APY gives a default risk premium of 2%.
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