Question

What is meant by “risk premium”? Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Answer 1

The concept of a risk premium is used mostly by investors and finance students studying and dealing with the financial markets. Specifically, it is usually applied to equities and companies as a measure of how much the potential investor needs to be compensated to take on the extra risk when compared to a “risk-free” investment, which is usually the US 10 year Treasury. It is also used to measure the riskiness of a company or industry during a valuation, where smaller companies have a higher premium than a larger, more established, company. Risk premium represents the extra return above the risk-free rate that an investor needs in order to be compensated for the risk of a certain investment. In other words, the riskier the investment, the higher the return the investor needs.

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anti cyclical, rising during recessions and falling during booms.