Question

Given a risky corporate bond with a 250 basis point (bps) credit spread over an equivalent default-free (sovereign) bond, if an investor has historical data for applicable default and recovery rates, what components of the credit spread can be estimated? What risk exposures remain in the residual components?

Answer 1

Components of ( Default Risk - Recovery Rates) can be estimated of the credit spread. This difference describe the components of expected loss premium.But empirically past result says that this components affects up to a part of the credit spread.

Components of the risk exposures remains in the residuals are :

• Risk premium - Unexplained risk of the corporate that can not be diversified
• Liquidity premium - Due to uncertainity of bond market there is a liquidity premium associated with the bond.
• Taxes - Corporate Bonds are subject to taxable by govt but sovereign reasury securities are not.