Question

True or false? The expected rate of return to the holder of a corporate bond is higher than the bond’s yield to compensate the holder for the risk of the bond defaulting. Justify

Answer 1

A bond default takes place when the bond issuing Company fails to make interest or principal payment within the due date. Defaults typically occur when the bond issuer has run out of cash to pay its bondholders, and since defaulting on a bond severely restricts the issuer’s ability to acquire financing in the future, a default is usually a last resort—and therefore a sign of severe financial distress.

Deafulting doesn;t mean that the lender won't be able to honor the bond's obligations in entirety, it just means that either of the two (interest or principal payment) has been defaulted or not paid on time.

As and when a deafult occurs, there is a concept called the 'recovery rate' which is equal to the market value of bond as a percentage of the face value of the bond.

The compensation of a defaultable bond has the following components:

covering the expected loss from default, i.e, Probability of default * loss given default. This ensures that the expected return of a defaultable bond is equal to the expected return of a default-free bond with the same maturity. Also, it factors in a risk premium to count for contingency (realized loss from deafult may exceed the expected loss)

As a result, holders of bonds which are prone to default expect an extra return for holding the bond and taking the default risk. They basically expect to earn more than the default-free interest rate as an incentive for taking risk.