Introduction to Finance

ETHICAL
Sometimes corporations issue bonds with ratings lower than Baa. These are called 
high-yield or junk bonds
because they have a substantial probability of default. While many 
institutional investors are restricted to investing in only investment grade
 
(Baa-rated or higher) 
corporate debt, others are permitted to invest in high-yield, high-risk corporate debt. Recall 
investment grade bonds 
ratings 
of Baa or higher that meet fi nancial 
institution investment standards
high-yield or junk bonds 
bonds 
that have a relatively high 
probability of default
TA B L E 8 . 4
Default Risk Premiums on Corporate Bonds at Selected Dates
March 
1980
Nov. 
2001
Oct. 
2006
Oct. 
2008
Dec. 
2012
Dec. 
2015
Aaa-rated corporate bonds
13.0%
7.0%
5.5%
5.2%
3.67%
3.97%
Less: 20-year Treasury bonds
12.5
5.3
4.9
4.2
2.54
2.61
Equals: default risk premium
on Aaa-rated bonds
.5
1.7
.6
1.0
1.13
1.36
Baa-rated corporate bonds
14.5
7.8
6.4
6.3
4.63
5.46
Less: 20-year Treasury bonds
12.5
5.3
4.9
4.2
2.54
2.61
Equals: default risk premium
on Baa-rated bonds
2.0
2.5
1.5
2.1
2.09
2.85
Source: 
Selected Interest Rates
, Board of Governors of the Federal Reserve System, http://www.federalreserve.gov.

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C H A PT E R 8 Interest Rates
the discussion in Chapter 2 about the savings and loan associations crisis that was caused 
in part by corporate defaults on high-yield or junk bonds that were held by S&Ls. Michael 
Milken, who was at Drexel Burnham Lambert at the time, was instrumental in getting those 
S&Ls and other institutions able to purchase junk bonds to do so. Some individuals would 
argue that the purchasers of junk bonds were sophisticated enough to make rational risk-return 
decisions; 
caveat emptor
—let the buyer beware. Other individuals charged that unethical and 
illegal behavior on the part of the marketers of junk bonds contributed to the failure of many 
of the issuers of the bonds as well as the purchasers (particularly S&Ls) of the bonds. In 1989, 
Milken was sent to prison and Drexel Burnham Lambert went bankrupt.