How to Find a Default Risk Premium on a Corporate Bond

By Motley Fool

There's generally no such thing as a risk-free investment, and that's especially holds true when it comes to corporate bonds. Companies issue these debt instruments to help pay for things such as operating expenses and product development. When a company issues bonds, it borrows money from investors and pledges to pay back the principal plus interest in return.

When investors buy bonds, they're essentially lending money to a company and assuming a degree of default risk. A company is considered to be in default of its bond obligations if it fails to make a payment as scheduled. The more likely a company is to default, the more risky an investment it's considered to be. To offset this risk, investors will generally demand a higher rate of return, so a default risk premium is built into the price of bonds.

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Calculating a bond's default risk premiumThe default risk premium is essentially the anticipated return on a bond minus the return a similar risk-free investment would offer. To calculate a bond's default risk premium, subtract the rate of return for a risk-free bond from the rate of return of the corporate bond you wish to purchase. Here's how to do it.

Step 1Determine the rate of return for a risk-free investment. The U.S. Treasury Department issues inflation-protected securities that are considered to be devoid of risk. With this type of investment, the principal increases with inflation and decreases with deflation, and the security itself is backed by the U.S. government, so it's considered safe. Let's assume the rate for a Treasury-issued risk-free security is 0.5%.

Step 2Subtract the Treasury's rate of return from the rate of the corporate bond you're looking to purchase. If you're looking to buy a bond offering a 9% annual rate of return, subtract 0.5% from 9% to arrive at 8.5%.

Step 3Subtract the estimated rate of inflation from this difference. If inflation is estimated at 5%, subtract 5% from 8.5% to arrive at 3.5%

Step 4Subtract any other premiums specific to the bond in question. Some bonds offer liquidity premiums, for example. If a bond can't easily be sold for cash, its issuer might offer investors an additional financial incentive in the form of a liquidity premium. If the bond you're looking at carries a liquidity premium of 1%, subtract that 1% from 3.5% to arrive at 2.5% for its default risk premium.

If you're concerned about buying bonds from a company that might default, look at that company's credit rating before moving forward. The higher the rating, the less likely the company is to default in the near term.

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