Introduction to Finance

Table 8.4
shows long-term interest 
rates for Treasury bonds and two corporate bonds with diff erent degrees of default risk. The 
characteristics of corporate bonds will be discussed in Chapter 10, but here it can be said 
default risk 
risk that a borrower 
will not pay interest and/or principal 
on a debt instrument when due

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8.6 Default Risk Premiums
213
that one way potential default risk is measured is through bond ratings. The highest rating 
assigned by Moody’s, a major bond-rating agency, is Aaa and indicates the lowest likelihood 
of default. Investors in these bonds require a small default risk premium over Treasury bonds. 
Baa-rated bonds have higher default risks but still are considered to be of reasonably high 
quality. 
Investment grade bonds
 
have ratings of Baa or higher and meet fi nancial institution 
(banks, pension funds, insurance companies, etc.) investment standards.
In March 1980, the default risk premium on corporate Aaa-rated bonds over 20-year 
Treasuries was 0.5 percentage point (i.e., 13.0 – 12.5 percent). The default risk premium on 
Aaa-rated corporate bonds had increased to unusually high 1.7 percentage points in November 
2001, refl ecting an economic downturn and concerns about terrorism in the United States. 
The October 2006 risk premium for Aaa-rated bonds remained low at a 0.6 percentage point 
diff erential over 20-year Treasury bonds. By October 2008, when the United States was 
in the midst of the 2007–08 fi nancial crisis and the 2008–09 recession, the risk premium 
for Aaa-rated bonds had increased to 1.0 percentage point. The Aaa-rated corporate 
bond risk premium was 1.13 percent in December 2012 and increased to 1.36 percent in 
December 2015.
The default risk premiums on Baa corporate bonds are generally better indicators of 
investor pessimism or optimism about economic expectations than are those on Aaa-rated 
bonds. More fi rms fail or suff er fi nancial distress during periods of recession than during peri-
ods of economic expansion. Thus, investors tend to require higher premiums to compensate 
for default risk when the economy is in a recession or is expected to enter one. Notice in 
Table 8.4 that the risk premium on Baa-rated bonds was two percentage points in March 
1980 (14.5 – 12.5 percent). The default risk premium on Baa-rated bonds was 2.5 percentage 
points in November 2001 and refl ected concerns about the slowing of economic activity in the 
United States and continued uncertainty after the terrorist attack on September 11, 2001. As 
of October 2006, the risk premium on Baa-rated corporate debt was 1.5 percentage points over 
the interest rate on 20-year Treasury bonds. 
The Baa-rated bond risk premium increased to 2.1 percentage points by October 2008, 
due to the fi nancial diffi
culties in the United States. Baa-rated corporate bonds relative to 
20-year Treasury bonds exhibited a 2.09 percent risk premium in December 2012 and a 2.85 
percent premium in December 2015. The relatively high default risk premium at the end 
of 2015 refl ects concern about possibly slower economic growth. Being risk adverse, bond 
investors will require higher expected additional compensation when they believe the probab-
ility of default increases.